An Introduction to Investment Products. To discuss your personal financial needs, please contact: enter contact information here

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1 An Introduction to Investment Products To discuss your personal financial needs, please contact: enter contact information here

2 1. Which answer best ranks the asset classes below in order of market risk, from lowest to highest, based on long-term historical risk? A. Domestic large-cap value E. International equity B. Short-term bonds C. Domestic large-cap equity F. Long-term bonds G. Domestic mid-cap value D. Cash a. D, B, F, A, C, G, E c. D, F, B, C, A, G, E b. D, F, A, B, C, G, E d. B, D, F, A, C, G, E Answer: a All things being equal, cash, or money market funds, carries the least amount of investment risk of all asset classes, but it also offers the lowest potential return. Bonds are generally less risky than equities, with shortterm issues the least volatile or lowest risk. Among equity funds, large caps are considered less risky than mid-caps or small caps, and value funds less risky than growth funds. International equity carries higher risk due to the political and currency risk associated with foreign investments. Note that the relative risks of different asset classes are based on longterm historical returns over different market cycles and that asset class risk at any given time is also a function of interest rates and other market factors. 2. Risk-adjusted return is a key metric for determining asset class performance and its suitability for and share of a particular allocation. How is risk-adjusted return usually measured? a. By the ratio of a fund s total return to the prevailing market interest rate, as measured by the federal funds rate. b. By dividing a fund s capital appreciation by its dividends, adjusted for splits. c. By the ratio of a fund s excess total return divided by the standard deviation of those returns over a specific time period, also known as the Sharpe ratio. d. By subtracting the risk-free return usually the rate paid on overnight money market securities from a fund s total return. Answer: c Risk-adjusted return is commonly measured by the Sharpe ratio, which takes into consideration a fund s excess total returns as well as the volatility of those returns. Excess total returns represent total returns in excess of the risk-free return usually the rate paid on overnight money market securities.

3 3. The efficient frontier refers to: a. The threshold at which a specific asset class is considered the most efficient choice for a stated return. b. The point at which an asset class achieves tax efficiency. c. The curve formed by plotting the ratio of risk versus return for different asset classes or combinations thereof. d. The point at which it is most efficient to sell a security, based on price appreciation and holding period. e. The combination of asset classes in a given portfolio that most efficiently serves the investor s risk profile. Answer: c The efficient frontier is used by analysts and portfolio managers to illustrate the risk/reward characteristics of different investments. The curve formed by these points represents the most efficient combinations of asset classes for given levels of risk. Asset allocations are structured along this efficient frontier with the goal of minimizing risk for any given risk profile. 4. Which answer best matches these benchmarks to their asset classes? A. Large-cap stocks 1. 3-month Treasury bill yield B. Money market securities C. Small-cap stocks D. U.S. corporate, government and agency securities 2. Barclays Aggregate Bond Index 3. S&P 500 Index 4. Russell 2000 Index 5. MSCI EAFE Index E. International stocks a. A(3); B(1); C(4); D(2); E(5) c. A(5); B(4); C(3); D(2); E(1) b. A(2); B(3); C(1); D(5); E(2) d. A(4); B(1); C(5); D(3); E(2) Answer: a Different benchmarks are used to gauge the performance of different asset classes. Although fund managers may use other benchmarks to measure their fund against, those listed here are widely regarded as standard benchmarks for their asset classes: the S&P 500 for large-cap stocks; the 3-month Treasury bill yield for money market securities; the Russell 2000 for small-cap stocks; the Barclays Aggregate Bond Index for domestic corporate, government and agency securities (not municipal bonds); and the MSCI EAFE Index for international stocks.

4 5. Match the asset class with the risk most commonly associated with it: A. Stocks 1. Credit risk B. Bonds C. Money market securities D. International stocks 2. Inflation risk 3. Investment risk 4. Currency risk a. A(1); B(2); C(3); D(4) b. A(3); B(1); C(2); D(4) c. A(4); B(3); C(2); D(1) d. A(2); B(1); C(3); D(4) All investments involve some form of risk, and most carry several different types of risk. For stocks, the principal risk is investment risk the risk that the price will decline and investors will lose money. Bonds carry credit risk the risk that the issuer will default on the payment of interest or principal. Money market securities, although less risky than stocks or bonds, involve inflation risk the risk that their yield will fall below the inflation rate, effectively undermining their value in real terms. Among other risks, international stocks entail currency risk the risk that their value will decline as a result of fluctuations in currency rates. 6. Which of the following is NOT considered characteristic of growth stocks or funds? a. Relatively high P/E ratio b. Relatively high dividend yield c. Above-average earnings growth d. High ratio of price to book value Growth stocks represent companies that have demonstrated better-thanaverage gains in earnings in recent years and are expected to continue delivering high levels of profit growth. Growth stocks typically have a higher P/E ratio than the broader market and have a higher price-to-book ratio. However, they do not usually have a higher dividend yield. On the contrary, growth companies typically plough the bulk of their earnings back into capital investment to fuel future growth rather than pay them out in dividends.

5 7. Fixed-income securities include all but which of the following: a. U.S. Treasury securities b. Dividend-paying utility stocks c. Corporate bonds d. Agency securities e. Variable rate municipal bonds Fixed-income securities represent any securities that offer a specified rate of return, even if that rate is pegged to a market rate by a formula, such as variable rate bonds. Stocks, even steady dividend payers, are not considered fixed-income securities, since company management has full discretion to modify or eliminate the dividend at any time. Fixedincome securities generally offer lower risk than equities and often comprise the lion s share of retirement income portfolios. 8. What is the difference between international funds and global funds? a. International funds invest only in developed country securities, while global funds invest in emerging market securities as well. b. International funds invest in any type of foreign security, while global funds invest only in American Depositary Receipts (ADRs) of foreign issues. c. International funds invest only in non-u.s.-based securities, whereas global funds invest in both domestic and foreign issues. d. The two refer to the same thing: any funds that invest internationally. Answer: c International funds invest exclusively in non-u.s.-based securities, whereas global funds invest in both domestic and foreign issues. Both international and global funds may invest in ADRs or other types of securities, and both may invest in developed or emerging country securities, depending on the fund objective.

6 9. High-yield or junk bonds refer to: a. Bonds issued by companies, government agencies or municipalities rated C or lower. b. Bonds issued by companies rated BB or lower. c. Bonds issued by companies rated C or lower. d. Bonds issued by companies, government agencies or municipalities rated BB or lower. e. Bonds placed on Credit Watch by one of the major rating services. Answer: d High-yield bonds were coined junk bonds because of their BB or lower rating from major rating services such as Standard & Poor s or Moody s. These ratings are considered below investment grade, due to their issuers questionable financial situations. These situations vary widely from financially distressed firms to highly leveraged new companies simply aiming to pay off debts. Junk bonds typically offer higher yields than investment-grade bonds to compensate for their higher risk. 10. If Bond A and Bond B are identical in every way (same maturity date, coupon, etc.) but Bond A is of a higher credit quality, what would you expect to see? a. A has a higher yield and lower price. b. B has a higher yield and lower price. c. A has a higher yield and higher price. d. B has a higher yield and higher price. Bonds with higher credit quality usually have lower yields than lowerquality issues because they carry less risk. Since all bonds have an inverse relationship between yield and price, the higher-yielding bond would carry a lower price, assuming all other things are equal.