Principles of Investments
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Course Introduction
Principles of Investments provides a comprehensive introduction to the fundamental concepts, tools, and strategies used in the investment process. The course covers topics such as financial markets and instruments, portfolio theory, risk and return analysis, security valuation, and the role of efficient markets. Students will explore different asset classes, including stocks, bonds, and mutual funds, and gain insights into diversification, asset allocation, and behavioral finance. Emphasis is placed on practical application and decision-making skills, preparing students to evaluate investment opportunities and understand the dynamic nature of the investment environment.
Recommended Textbook Fundamentals of Investments 6th Edition by
Bradford D. Jordan
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Chapter 1: A Brief History of Risk and Return
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Q1) Eight months ago, you purchased 300 shares of a non-dividend paying stock for $27 a share. Today, you sold those shares for $31.59 a share. What was your annualized rate of return on this investment?
A) 17.00 percent
B) 21.45 percent
C) 25.50 percent
D) 26.55 percent
E) 28.00 percent
Answer: D
Q2) The average risk premium on large-company stocks for the period 1926-2009 was:
A) 6.7 percent.
B) 7.9 percent.
C) 8.5 percent.
D) 12.3 percent.
E) 13.6 percent.
Answer: B
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Chapter 2: The Investment Process
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Q1) You just sold short 700 shares of Highway Construction stock for $31 a share. The initial margin requirement is 70 percent and the maintenance margin is 35 percent. Construct a balance sheet depicting this transaction.
Answer: Balance Sheet:
Assets:
Cash: $14,490 (proceeds from selling short 700 shares at $31 per share)
Equity: $21,000 (initial margin requirement at 70% of the total value of the short sale)
Liabilities: None Net Equity: $6,510
As the stock price fluctuates, the maintenance margin of 35% will come into play. If the value of the short sale falls below this level, the investor will need to add more funds to meet the maintenance margin requirement.
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Chapter 3: Overview of Security Types
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Q1) An agreement that grants the owner the right, but not the obligation, to buy or sell a specific asset at a specified price during a specified time period is called a(n) _____ contract.
A) futures
B) obligatory
C) quoted
D) fixed
E) option
Answer: E
Q2) A call option is an agreement that:
A) obligates both the buyer and seller to a future transaction.
B) grants the seller the right to buy a security at a predetermined price.
C) gives the buyer the right to purchase an asset at some point in the future.
D) grants the seller the right, but not the obligation, to sell an asset.
E) presets a price but not a time period.
Answer: C
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Chapter 4: Mutual Funds
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Q1) Five months ago, you purchased 200 shares of a mutual fund at an offering price of $54 a share. The fund imposes a front-end load of 4.5 percent and has total annual expenses of 1.08 percent. The NAV of the fund today is $52.40. There were no fund distributions during these five months. What is your holding period return on this investment?
A) -2.96 percent
B) -1.92 percent
C) 1.44 percent
D) 1.89 percent
E) 2.26 percent
Q2) ETFs are:
A) limited to diversified index funds.
B) generally held until they mature.
C) sponsored primarily by large investment banks.
D) based on market-cap-weighted indexes only.
E) claims on shares held in a trust.
Q3) What are the primary differences between an ETF and an ETN?
Q4) Which type of investor is most apt to purchase municipal bond funds and why?
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Page 6
Chapter 5: The Stock Market
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Q1) Wilson just placed an order with his broker to purchase 500 of the outstanding shares of GE. This purchase will occur in which one of the following markets?
A) primary
B) secondary
C) third
D) fourth
E) fifth
Q2) Which one of the following statements is correct regarding the NYSE uptick rule?
A) The rule prevents any further selling of shares when the last sale was an uptick.
B) The rule prevents any further selling of shares when the last sale was a downtick.
C) The rule prevents short-selling except following an uptick.
D) The rule prevents short-selling except following a downtick.
E) The rule was recently adopted to limit market volatility.
Q3) Describe the primary advantage and disadvantage of a limit sell order.
Q4) Explain the NYSE uptick rule and the current controversy pertaining to that rule.
Q5) Describe some of the recent changes in the structure and operations of the NYSE.
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Chapter 6: Common Stock Valuation
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Q1) Home Interiors has net income of $248,000. The firm has decided to pay $160,000 of that income out to the shareholders. What is the firm's retention ratio?
A) .355
B) .412
C) .450
D) .588
E) .645
Q2) You would like to know the value of a firm's equity today in relation to the cost of that equity. Which one of the following ratios will provide you with this information?
A) price-earnings
B) price-book
C) price-sales
D) price-cash flow
E) price-assets
Q3) The residual income model for valuing a stock suffers from some of the same estimating errors as the dividend growth model. Identify and explain these estimating errors.
Q4) Identify three causes for a decrease in a firm's sustainable rate of growth.
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Chapter 7: Stock Price Behavior and Market Efficiency
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Q1) Ted is an engineer for True Tech and has just discovered a revolutionary method for strengthening metals. He knows this knowledge will add value to True Tech's stock. Ted happens to mention this discovery and its value to his neighbor, Fred. Fred can be charged with insider trading if he:
A) continues to hold the True Tech shares of stock he already owns.
B) shares this information with another neighbor.
C) sells his shares in True Tech immediately after the news of the discovery is announced.
D) provides this information to a friend who will trade the stock and split the profits with him.
E) buys shares in True Tech immediately after the news is announced and then shortly thereafter sells the shares at a profit.
Q2) From the end of 1989 to the spring of 2003, the Nikkei Index declined in value approximately _____ percent.
A) 50
B) 60
C) 70
D) 80
E) 90
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Chapter 8: Behavioral Finance and the Psychology of Investing
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Q1) Explain the basics of prospect theory and provide an example that illustrates this theory.
Q2) Ted constantly ignores the effects of inflation on money. Ted is suffering from which one of the following?
A) endowment effect
B) money illusion
C) regret aversion
D) myopic loss aversion
E) sunk cost fallacy
Q3) A "block trade" is a trade in excess of how many shares?
A) 1,000
B) 5,000
C) 10,000
D) 50,000
E) 100,000
Q4) Give some examples of how overconfidence affects investor behavior along with the results that might be expected based on that behavior.
Q5) Draw a basic Elliott Wave Pattern. Identify each wave and indicate the waves that are "corrective" and those that are "impulsive".
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Chapter 9: Interest Rates
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Q1) A bond has a face value of $20,000 and matures in 62 days. What is the bank discount yield if the bond is currently selling for $19,792.30?
A) 4.67 percent
B) 4.87 percent
C) 5.48 percent
D) 5.78 percent
E) 6.03 percent
Q2) Which one of the following statements is correct concerning a Treasury bill?
A) The asked discount indicates the amount a bond dealer is willing to pay to purchase a Treasury bill.
B) The asked yield on a Treasury bill is a bond equivalent yield.
C) The asked discount for a Treasury bill is greater than the bid discount.
D) The asked yield for a Treasury bill is computed based on a 360-day year.
E) The bid price on a Treasury bill is computed based on a 365, or 366-day year.
Q3) Identify and describe four of the six components of nominal interest rates as supported by modern term structure theory.
Q4) Write a short paragraph comparing a bank discount rate to a bond equivalent rate.
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11
Chapter 10: Bond Prices and Yields
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Q1) Which one of the following measures a bond's sensitivity to changes in market interest rates?
A) yield to call
B) yield to market
C) duration
D) immunization
E) target date valuation
Q2) Blue Water Homes has 8 percent bonds outstanding that mature in 13 years. The bonds pay interest semiannually. These bonds have a par value of $1,000 and are callable in 2 years at a premium of $75. What is the yield to call if the current price is equal to 103.25 percent of par?
A) 7.51 percent
B) 7.70 percent
C) 8.06 percent
D) 8.98 percent
E) 9.66 percent
Q3) Identify and briefly explain four of Malkiel's five theorems.
Q4) Explain the conditions under which an investor should place more reliance on the yield-to-call than on the yield-to-maturity.
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Chapter 11: Diversification and Risky Asset Allocation
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Q1) How will the returns on two assets react if those returns have a perfect positive correlation?
I. move in the same direction
II. move in opposite directions
III. move by the same amount
IV. move by either equal or unequal amounts
A) I and III only
B) I and IV only
C) II and III only
D) II and IV only
E) III only
Q2) Tall Stand Timber stock has an expected return of 17.3 percent. What is the risk-free rate if the risk premium on the stock is 12.4 percent?
A) 4.90 percent
B) 5.30 percent
C) 5.67 percent
D) 6.55 percent
E) 7.17 percent
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Chapter 12: Return, Risk, and the Security Market Line
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Q1) Farm Tractors, Inc., stock has a beta of 1.02 and an expected return of 12.8 percent. The risk-free rate is 3.9 percent. What is the market rate of return?
A) 6.67 percent
B) 8.90 percent
C) 9.08 percent
D) 11.57 percent
E) 12.63 percent
Q2) You own three stocks which have betas of 1.16, 1.34, and 1.02. You would like to add a fourth security such that your portfolio beta will match that of the market. Given this situation, the new security:
A) must have a beta of 1.0.
B) must have a beta of zero.
C) could be a U.S. Treasury bill.
D) could have any beta greater than 1.0.
E) must have a portfolio weight of 50 percent or more.
Q3) Explain the relationship between the security market line and market efficiency.
Q4) Identify and describe each of the three components of a security's expected return according to the capital asset pricing model.
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Page 14
Chapter 13: Performance Evaluation and Risk Management
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Q1) Which one of the following Value-at-Risk measures would be most appropriate for a portfolio designed for a very risk-adverse investor?
A) Prob (Rp \(\le\) - .20) = 100%
B) Prob (Rp \(\le\) - .15) = 50%
C) Prob (Rp \(\le\) - .10) = 25%
D) Prob (Rp \(\le\) - .10) = 10%
E) Prob (Rp \(\le\) - .05) = 1%
Q2) Which measure would you use to know whether alpha is truly significant or just the result of random chance?
A) Jensen's alpha
B) Information ratio
C) Jensen-Treynor alpha
D) Sharpe ratio
E) Treynor ratio
Q3) A conservative investor has a well-diversified portfolio but is still concerned about two things. First, he is concerned about the downside risk and secondly, he is concerned whether he is earning a sufficient rate of return to compensate for the total risk he is assuming. How could you quantify these concerns for this investor?
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Page 15
Chapter 14: Futures Contracts
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Q1) A futures price is a price that is negotiated _____ and paid _____.
A) today; in the future
B) today; today
C) in the future; in the future
D) in the future; today
E) either today or in the future; in the future
Q2) Your broker requires an initial margin of $4,725 per futures contract on soybeans and a maintenance margin of $3,500 per contract. Soybean futures contracts are based on 5,000 bushels and quoted in cents per bushel. Yesterday, you bought 4 soybean futures contracts at the closing settlement price of 1372. Today, the settlement quote is 1340. All margin calls restore margin levels to their initial margin level. Will you receive a margin call and if so, for what amount?
A) no margin call
B) call for $425
C) call for $487
D) call for $1,650
E) call for $6,400
Q3) Explain why some futures contracts are settled in cash while others are not. Provide an example of each.
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Page 16
Chapter 15: Stock Options
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Q1) You bought a put with a strike price of $25. The current stock price is $23. What is the current payoff value of this option?
A) -$2
B) -$1
C) $0
D) $1
E) $2
Q2) SLK stock is selling for $28 a share. A $30 call on this stock is priced at $2. What is your maximum profit and maximum loss if you buy the stock and write the call? How does this compare to your maximum profit and loss if you write the call but do not purchase the stock?
Q3) The value of an option is dependent upon the value of the underlying security. This relationship defines an option as which one of the following?
A) equity security
B) fixed income security
C) derivative security
D) transfer security
E) dependent security
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Chapter 16: Option Valuation
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Q1) Mike was granted stock options on 1,000 shares of his employer's stock. The stock is currently selling for $27.70 a share and has a standard deviation of 36 percent. The option's strike price is $27.50 and the time to maturity is 10 years. What is the value of each option given a risk-free rate of 3 percent? Assume that no dividends are paid.
A) $14.35
B) $15.67
C) $17.80
D) $20.15
E) $22.70
Q2) You own 1,800 shares of Textile stock which is currently valued at $62 a share. The $65 put has a premium of $4.26 and a put delta of -.60. What position should you take in $65 put contracts to hedge your stock against a $1 decrease in price?
A) buy 3 contracts
B) buy 30 contracts
C) buy 300 contracts
D) write 3 contracts
E) write 30 contracts
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Chapter 17: Projecting Cash Flow and Earnings
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Q1) Which one of the following is NOT a financing cash flow according to standard accounting practice?
A) new issue of stock
B) repurchase of stock
C) new issue of debt
D) interest payments
E) dividend payments
Q2) For the year, Widgets Manufacturing, Inc. increased its current accounts by $52,000, decreased its current liabilities by $38,000, and decreased its fixed assets by $31,000.
What is the investment cash flow for the year?
A) -$31,000
B) -$12,000
C) $19,000
D) $31,000
E) $48,000
Q3) Why is the expected rate of sales growth so critical to pro forma statements?
Q4) What value does the Statement of Cash Flows add to the financial statements of a firm?
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Chapter 18: Corporate Bonds
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Q1) A bond has 5 years until it can be called, a 7 percent coupon, and a $1,000 face value. The bond has a market value of $1,030.40 and a yield to call of 7.28 percent. What is the call premium?
A) $40
B) $50
C) $60
D) $70
E) $80
Q2) A firm had a major fire which hampered operations for the past year. As a result, the firm discontinued all dividends for one year. Next month, the firm will resume paying dividends. The normal quarterly payments are $1.50 for the cumulative preferred shares and $0.95 for the common shares. How much will the firm need to pay the preferred shareholders per share if the firm also pays a common dividend?
A) $0.00
B) $4.75
C) $6.00
D) $7.50
E) $8.00
Q3) How is the minimal value for a convertible bond determined?
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Page 20
Chapter 19: Government Bonds
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Q1) Which one of the following features applies to all Treasury bonds currently being offered?
A) noncallable
B) sold at a deep discount
C) zero-coupon
D) mature in 10 years or less
E) callable within 5 years of issue
Q2) Which of the following are securities issued by the U. S. Treasury?
I. Government Account Series
II. T-bills
III. U.S. Savings Bonds
IV. T-notes
A) I and III only
B) II and IV only
C) II, III, and IV only
D) I, II, and IV only
E) I, II, III, and IV
Q3) Explain how the imputed interest is computed on a U. S. Treasury bill.
Q4) What is the advantage of purchasing a STRIPS over a Treasury note?
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Chapter 20: Mortgage-Backed Securities
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Q1) What are the securities that are created when a mortgage pool is divided into a number of tranches called?
A) split strips
B) divided CMOs
C) sequential CMOs
D) indexed mortgage splits
E) tranche pools
Q2) Which one of the following is a security that only pays the principal cash flows to investors?
A) split strip
B) interest-only strip
C) amortized strip
D) principal-only strip
E) final strip
Q3) Explain what a reverse mortgage is, how it works, and who it is intended to help.
Q4) How do CMOs increase the availability of mortgage funds?
Q5) What are the advantages and the disadvantages of a homeowner selecting a 30-year mortgage rather than a 20-year mortgage?
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