2) Real estate investments are more liquid than stocks most of the time. Answer: FALSE Diff: 1 Topic: Real Estate AACSB: Analytical Thinking

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1 Personal Finance: Turning Money into Wealth, 7e (Keown) Chapter 11 Investment Basics 11.1 Before You Invest 1) As the owner of a corporate bond this means I hold an ownership position within that corporation. Topic: Bonds 2) Real estate investments are more liquid than stocks most of the time. Topic: Real Estate 3) Investing in bonds is generally less risky than investing in stocks. Topic: Bonds 4) Stocks represent a legal obligation for the issuing company to pay dividends, whether the company has made a profit or not. Topic: Stocks 5) Bonds are always a safe investment if held to maturity. Topic: Bonds 6) To begin your savings plan it is a good idea to set aside your savings first and only spend what is left over. Topic: Financial Goals AACSB: Reflective Thinking 1

2 7) On the TV show "The Big Bang Theory" the main characters are frequently seen purchasing comic books. Purchasing rare comic books is an example of investing. Topic: Speculation 8) An option gives you the right to buy or sell the underlying asset at a set price on or before the option's maturity date. Topic: Derivatives 9) Investing in assets such as collectable Barbie Dolls or Beanie Babies are both example of speculating. Topic: Investment 10) Purchasing derivatives is a form of speculating. Topic: Derivatives 11) Long-term capital gains have favorable tax treatment over earned income. Topic: Capital Gains/Loss 12) A lending type investment, such as a corporate bond, represents a legal obligation for the issuer to pay its creditors back. Topic: Lending 13) A typical bond will pay annual coupon payments until it matures, at which time it will surrender its par value to the owner of the bond. Topic: Bonds 2

3 14) If the corporation that issued a bond goes bankrupt, the bondholders are paid before stock holders are paid from any remaining assets of the corporation. Topic: Bonds 15) A company that doesn't make a dividend payment is insolvent and may be forced into bankruptcy by the stockholders. Topic: Stocks 16) The rate of return on an investment is calculated by dividing the capital gain or loss plus the cash flows by the initial investment amount. Topic: Returns 17) Investing in bonds tends to be riskier financial strategy than investing in common stocks. Topic: Returns 18) Which of the following investors will potentially receive dividends on their investments? A) Bondholders B) Stockholders C) Debt holders D) Derivative holders E) Both B and D are correct. Topic: Dividends 3

4 19) An investor owns stock from seven different companies, two rental houses, and three government bonds. Together these assets are considered to be the investor's A) collection. B) derivative holding. C) asset class. D) portfolio. E) none of the above. Topic: Portfolio 20) The date is the date at which the bond issuer must repay the loan or borrowed funds. A) premium B) ending C) completion D) maturity E) none of the above Topic: Maturity Date 21) Suppose that you purchased a machine several years ago for your company. You recently sold the machine for more than you paid. This is an example of a A) capital carry-forward. B) non-taxable gain. C) capital gain. D) windfall. E) none of the above. Answer: C Topic: Capital Gains/Loss 22) The is the stated amount on the face of a bond, which the firm is to repay at the maturity date. A) historical value B) debt price C) par value D) relevant value E) none of the above Answer: C Topic: Bonds 4

5 23) The rate is the interest to be paid annually on a bond as a percentage of its par value. A) base B) coupon interest C) face interest D) compound interest E) none of the above Topic: Bonds 24) You are considered to be engaging in when you purchase an asset whose value depends solely on supply and demand. A) investing B) speculation C) hedging D) optioning E) none of the above Topic: Speculation 25) A security whose value is based solely on the value of other assets is called a security. A) capital option B) hedging C) derivative D) alternative asset E) none of the above Answer: C Topic: Derivatives 26) When you purchase an asset that generates a return, it is generally considered to be A) an investment. B) speculation. C) a windfall. D) an expected returner. E) none of the above. Answer: A Topic: Investment 5

6 27) If you bought a 20-year bond issued by the government, with a par value of $1,000 and an interest rate of 8%. At maturity you will be returned the principal of A) $80. B) $500. C) $800. D) $1,000. E) $1,600. Topic: Bonds 28) As a young college graduate, your biggest investment ally is A) leverage. B) a windfall. C) tax-free investments. D) time. E) derivatives. Topic: Financial Planning AACSB: Reflective Thinking 29) You can make investments on a basis, which means that not only does your investment grow free of taxes, but the money you invest isn't taxed until you liquidate your investment. A) tax-eliminated B) progressive tax C) tax-deferred D) asset management Answer: C Topic: Financial Planning 30) Long term capital gains are taxed at percent. A) 8 B) 10 C) 15 D) 25 E) 40 Answer: C Topic: Leverage 6

7 31) Petrina was told by a successful friend to invest in stocks and income-producing real estate. Both of these are examples of investments. A) ownership B) lending C) risk-free D) short-term E) liquid Answer: A Topic: Ownership 32) If you purchase some shares of stock A) you may earn dividends. B) you will definitely earn dividends. C) you may earn coupon interest. D) you will definitely earn coupon interest. Answer: A Topic: Income Returns 33) Jennifer has money invested in stocks. She earns a return on her investment, which is a portion of the company's profits, called A) interest. B) a return. C) dividends. D) growth. E) retained earnings. Answer: C Topic: Dividends 34) What is an advantage to being a "preferred" stock holder? A) Preferred stock holders always get to vote for the board of directors of the company. B) Preferred stock holders receive a better coupon interest rate. C) Preferred stock holders receive dividend payouts before common stock holders do. D) Preferred stock holders never pay commissions on their stock trades. E) There are no advantages to being a preferred stock holder. Answer: C Topic: Lending 7

8 35) Hern MacTavish only invests in lending investments. If his financial advisor gave him the list below, which might Hern invest in? A) Saving accounts B) Stocks C) Income-producing real estate D) Bonds E) Both A and D Answer: E Topic: Lending 36) Real estate investments can be income-producing investments. Which of these would be included as an income-producing real estate investment? A) An apartment complex B) A shopping mall C) Your personal home D) All of the above E) Only A and B above Topic: Real Estate 37) The difference between an investment and speculation is that an investment while speculation depends solely on to produce results. A) costs less; the economic conditions B) generates a return; supply and demand C) costs less; generating a return D) depends on supply and demand; economic conditions E) depends on supply and demand; generating a return Topic: Investment 38) Just as valuable as the tax break on capital gains income is the fact that you don't have to claim it and, therefore, you don't pay taxes on the asset until you A) have an equal match in personal income. B) sell it. C) retire. D) file your next years' taxes. Topic: Financial Planning 8

9 39) Which of the following questions is relevant to setting investment goals? A) If I don't accomplish this goal, what are the consequences? B) Am I willing to make the financial sacrifices necessary to meet this goal? C) When do I need this money? D) How much money do I need to accomplish this goal? E) All of the above are relevant. Answer: E Topic: Financial Goals AACSB: Reflective Thinking 40) An option gives its owner the right to buy or sell an asset. This asset is generally A) preferred stock. B) mutual funds. C) corporate bonds. D) common stock. E) None of the above are correct. Topic: Financial Planning 41) Lavon has his money invested into an asset that has averaged the following returns the last three years: +22%, -8%, +13%. Most likely what type of asset is he invested in? A) Corporate bonds B) Income producing real estate C) Gold coins D) Common stock Topic: Stocks 42) Latisha invested $1,000 in XYZ stock. Two years later she sold the stock for $1,200. During the time she owned the stock, she received a total of $80 in dividends. What was her total return on this investment? A) 8% B) 20% C) 23.33% D) 28% Topic: Returns 9

10 43) Tran purchased a house for a rental property for $100,000 five years ago. During the time he owned this rental, his net rental income was a total of $4,000. He just sold the property for $120,000. What was his average annual return on this investment? A) 4.0% B) 4.8% C) 20% D) 24% Topic: Returns 44) Juan purchased shares in ABC company for $5,000 three years ago. During these three years he received $600 in dividends. He just sold the stock for $4,300. What was his total return on this investment? A) 14% B) 2% C) 12% D) 14% Topic: Returns 45) Louis purchased $5,000 worth of stock three years ago and sold it today for $7,000. He received no dividends from this investment. Inflation averaged 4% during the three years he owned the stock. What was his annualized real rate of return on this investment? A) 4% B) 9.33% C) 13.33% D) 36% E) 40% Topic: Returns 10

11 46) Paula bought a stock for $200 last year and sold it today for $150. If she earned a dividend of $100 while she held the stock her rate of return was A) 50%. B) 25%. C) 25%. D) 33.33%. E) 50%. Answer: C Topic: Returns 47) If the total rate of return is multiplied by 1/N, where N is the number of years for which the investment was held, the result is the A) serialized rate of return. B) annualized rate of return. C) tax-free rate of return. D) capitalized rate of return. Topic: Returns 48) You purchased an investment for $1,000 on which you earned $120 investment last year. The inflation rate during that time was 3%. What was your real rate of return? A) 3% B) 9% C) 12% D) 15% E) None of the above Topic: Returns 49) You recently purchased a stock for $50. It is now worth $75, and it paid a $15 dividend during the two years you held it. What is your annualized rate of return on this stock? A) 80% B) 40% C) 27% D) 25% Topic: Returns 11

12 50) You recently purchased a stock for $25. It is now worth $35, and it paid a $5 dividend during the time you held it. Your rate of return on this stock is closest to which of the following? A) 60% B) -20% C) 43% D) 40% Answer: A Topic: Returns 51) You recently purchased 100 shares of stock at $15 per share. The stock is now worth $20 per share, and it paid a $2 dividend during the time you held it. Your rate of return on this stock is closest to which of the following? A) -20% B) 33% C) 35% D) 47% Topic: Returns 52) You recently purchased a stock for $30. It is now worth $40, and it paid a $5 dividend during the time you held it. Your rate of return on this stock is closest to which of the following? A) 67% B) 50% C) 38% D) 33% E) 17% Topic: Returns 53) What are the four financial questions that help focus on investing goals? Answer: - If I do not accomplish this goal, what are the consequences? - Am I willing to make the financial sacrifices necessary to meet this goal? - How much money do I need to accomplish this goal? - When do I need this money? Topic: Financial Goals AACSB: Reflective Thinking 12

13 54) A prerequisite to investing is to perform a financial reality check. Explain its 3 parts. alance your budget. If you do not live within your means, you will never be able to save, invest, or achieve any of your financial goals. Put a safety net in place by carrying adequate insurance life, health, auto, homeowner's, liability to protect your assets and you against catastrophes. Maintain adequate emergency funds in a safe investment of 6 to 9 months of takehome pay. Topic: Financial Planning AACSB: Reflective Thinking 55) Why is speculating in derivatives, futures contracts and options not appropriate for the typical, long-term investor? Answer: These are highly speculative securities that are not appropriate for the typical investor using their important money to reach their long-term goals. These securities require sophisticated knowledge and research not typically found in the average investor. Because they derive their value from other assets, these securities do not generate a return unless the underlying assets behave in a certain manner. Topic: Derivatives AACSB: Reflective Thinking 56) Compare and contrast lending and ownership investments. Answer: You actually lend someone your money in a lending investment, such as a saving account or a bond. The original investment or principal does not grow in a lending investment. It returns interest annually and the original investment when retiring it. Note: Bonds appreciate or depreciate in value based on changes in interest rates. Investing in bonds can lead to capital gain (loss) much the same as equities if timed properly. An ownership investment, such as stocks or income-producing real estate, provides an annual return plus the potential for appreciation or growth in value of the original principal. Topic: Investment 13

14 57) What is the purpose of return on investment? Answer: The return on investment communicates several pieces of important information. First the potential return signals the risk associated with the investment. Principle 8: Risk and Return go hand in hand tells us that the higher the potential return, the more risk associated with the investment. Secondly, the return signals the opportunity cost of the investment. An investment with a potential return of 6% means that you would be giving up the opportunity to earn a higher or lower return on another investment option. You would need to analyze the risk associated with each return to determine if one was more appropriate than the other. Lastly, the potential return communicates how likely it will be for you to obtain your financial goals. A low return may signal an investment that is to conservative for you to reach your long term goals. A high return may signal that the investment is to risky and inappropriate for your needs. Topic: Returns 11.2 A Look at Risk-Return Trade-Offs 1) The nominal rate of interest that investors demand will increase with an increase in the expected rate of inflation. Topic: Risk Premiums 2) The real rate of return is the nominal rate of return adjusted for inflation. Topic: Returns 3) If you are too conservative with your investments, they may not keep up with inflation. Topic: Returns 4) The real rate of return is the rate of return earned on an investment without any adjustment for inflation. Topic: Returns 14

15 5) When it comes to tax advantages, capital gains and dividend income are taxed at a lower rate than ordinary income. Topic: Taxes 6) The higher your marginal tax bracket, the less attractive tax-free investments become. Topic: Returns 7) During times of rising inflation, investments with fixed returns like a bond or bank CD are attractive investments to own. Topic: Inflation 8) The nominal rate of return is simply the real rate of return minus the inflation rate. Topic: Returns 9) If the nominal rate is 10% and inflation is 3%, the real rate of return is 7%. Topic: Returns 10) The real rate of return can never be a negative number. Topic: Returns 11) Interest rates are closely tied to the rate of inflation. Topic: Returns 15

16 12) Market risk deals with the inability to sell a security quickly at fair market value. Topic: Risk 13) Historically, U.S. government securities have been considered the safest, lowest-risk investment available. Topic: Risk 14) Some types of investments expose you to multiple sources of risk. Topic: Risk 15) Diversification eliminates all the risk from your portfolio. Topic: Diversification 16) Market risk is the risk of fluctuations in security prices due to changes in the market interest rate. Topic: Risk 17) One of the most important types of risk associated with real estate is the liquidity risk. Topic: Risk 18) The risk associated with the use of debt by the firm is business risk. Topic: Risk 16

17 19) Particularly, during election years, investors should make themselves aware of the risk resulting from unanticipated changes in the tax or legal environment. This is classified as political and regulatory risk. Topic: Risk 20) Diversification lowers risk, but it also lowers the expected return. Topic: Diversification 21) For the international investor, exchange rate risk is simply another layer of risk. Topic: Rider 22) Systematic risk can be effectively managed through diversification. Topic: Risk 23) Diversification works in one's portfolio because stock returns in one's portfolio do not always move in the same direction; as a result, the upswings and downturns in one's portfolio eliminate one another. Topic: Diversification 24) An investor with a low propensity for risk would avoid investments with high risk premiums. Topic: Risk Premiums 25) Unsystematic risk cannot be eliminated through diversification. Topic: Risk Premiums 17

18 26) Call risk is the risk to bondholders that a bond may be called away from them before maturity. Topic: Risk 27) Risk capacity refers to the strength of your financial safety net. Topic: Risk 28) Your emergency fund should always be invested in illiquid assets. Topic: Emergency Fund 29) Suppose that you are beginning an investment plan. You have decided that you want to retire in 30 years with $1,000,000 in your bank account at that time. How much would you need to invest at the end each of the next 30 years if you could earn 8%? A) $11,924, B) $83, C) $46, D) $22, E) $8, Answer: E Topic: Time Value of Money 30) One should keep in mind that when it comes to tax advantages, is/are better than. A) ordinary income; capital gains B) capital gains; ordinary income C) tax shelters; capital gains D) marginal rates; ordinary income Topic: Capital Gains/Loss 18

19 31) The nominal rate of return minus the inflation rate is called the A) stated rate of return. B) standard rate of return. C) real rate of return. D) Fisher effect. E) none of the above. Answer: C Topic: Returns 32) Historical rates of return for the last 82 years place at the highest end of the spectrum for risk and at the lowest end for risk. A) common stocks; T-Bills B) common stocks; long-term government bonds C) common stocks; long-term corporate bonds D) long-term corporate bonds; long-term government bonds Answer: A Topic: Returns 33) The rate of return earned on an investment is unadjusted for lost purchasing power. A) effective B) annual C) real D) nominal E) none of the above Topic: Returns 34) When market interest rates go up investors demand returns on other types of investments and when market interest rates go down, the return investors demand on other types of investments. A) lower; goes down B) higher; goes down C) lower; goes up D) higher return; goes up Topic: Interest Rates 19

20 35) While studying the chapter on investments in Personal Finance, Becky Hargrith found out that the is equal to the real rate of return plus the rate of inflation. A) adjusted rate B) long-term rate of return C) nominal interest rate D) real interest rate Answer: C Topic: Interest Rates 36) Alice learned that the difference between the real rate of return and the nominal or quoted rate of return is that A) the real rate is adjusted for inflation. B) the real rate is not adjusted for inflation. C) the nominal rate is adjusted for inflation. D) none of the above. Answer: A Topic: Returns 37) Principle #4, taxes affect personal finance decisions, tells us that several points hold true regardless of what we invest in. Jason found a point that was included on the list in error. Which of the following is it? A) The marginal tax rate is the rate you pay on the next dollar of earnings. B) Tax-free investments should be compared on a before-tax basis. C) You should consider tax-deferred investments. D) Capital gains are better than ordinary income when it comes to taxes. E) The higher your marginal tax bracket, the more attractive tax-free investments become. Topic: Taxes AACSB: Reflective Thinking 38) Lawrence Wright is slow in math. He has before him the equation of (ending value minus beginning value) and income return totalled, then divided by beginning value. This is used to find the A) rate of inflation. B) capital gain. C) capital loss D) rate of return. E) serialized rate of return. Topic: Returns 20

21 39) That portion of a stock's risk or variability that can be eliminated through investor diversification is called risk. A) unsystematic B) systematic C) volatility D) inflation E) portfolio Answer: A Topic: Risk 40) That portion of a stock's risk or variability that cannot be eliminated through investor diversification is called risk. A) unsystematic B) systematic C) unrealistic D) inflation E) volatility Topic: Risk 41) You have just purchased a large number of Italian bonds, and you reside in the United States. The variability in earnings that you might experience as the relationship between the euro and the U.S. dollar fluctuates is called A) currency volatility risk. B) international risk. C) exchange rate risk. D) fluctuation risk. E) none of the above. Answer: C Topic: Risk 42) Which of the following is not risk that can be diversified out of a portfolio of stocks? A) unsystematic B) systematic C) firm specific D) company-unique Topic: Risk 21

22 43) Bruce Lee owns stocks, bonds, real estate, gold coins, T-Bills, and gemstones. He has a(n) A) equity portfolio. B) default-proof portfolio. C) inflation-proof portfolio. D) diverse portfolio. E) risk adverse portfolio. Topic: Diversification 44) You are considering the purchase of a corporation's stock. You have noted that this particular corporation has a high use of debt, which is associated with risk. A) business B) financial C) corporate D) market E) none of the above Topic: Risk 45) Changes in the capital gains tax rate, or in the tax deductibility on municipal bonds are examples of risk. A) inflation B) political and regulatory C) interest rate D) exchange rate risk E) none of the above Topic: Risk 22

23 46) Barney Hopkins is the financial manager for Amax Corporation. He knows that risk deals with good or bad management decisions and is associated with his company's use of debt. A) market; business B) market; financial C) business; interest rate D) business; financial E) financial; business Topic: Risk 47) Many people never consider or think of the sources of risk that affect their investments. Which of the following is a risk associated with investing? A) Interest rate risk B) Inflation risk C) Business risk D) Financial risk E) All of the above Answer: E Topic: Risk 48) risk is simply the variability in the returns of an investment that is due to events that are unrelated to the overall market. A) Systematic B) Unsystematic C) Non-diversifiable D) Portfolio Topic: Risk Premiums 49) The risk that you will not be able to find a buyer at a fair market price, and will wind up having to sell for less than an asset's worth is called risk. A) inflation B) interest C) liquidity D) call Answer: C Topic: Risk 23

24 50) Alice just inherited an antique wood burning stove. While she appreciates the sentimental value of the stove she is concerned that an investment such as this might not be able to be converted into cash quickly at a fair market price. Alice is worried about on this as an investment. A) liquidity risk B) cash conversion C) maturity risk D) default risk E) none of the above Answer: A Topic: Risk Premiums 51) You own a bond issued by BMW, a German company. What kind of risk are you exposed to? A) Inflation risk B) Interest rate risk C) Exchange rate risk D) All of the above are correct. Topic: Risk 52) What type of investment would have a high risk premium associated with political and regulatory risk? A) A drug company B) A casino company C) A tobacco company D) All of the above are correct. Topic: Risk Premiums 53) Which of the following would have liquidity risk associated with it? A) A rare comic book B) A house C) A stamp collection D) All of the above are correct. E) All but A are correct. Topic: Risk 54) Albert just purchased a $1,000, 5.4%, 10-year bond when he heard about his friend Charlie 24

25 who just bought a similar bond at $1,000; 9.5%, 10-year bond. What kind of risk did Albert just experience? A) Interest rate B) Market C) Financial D) Business Answer: A Topic: Risk 55) Recently an oil rig in the Gulf of Texas blew up causing the value of your stock in the company who owns the oil rig to fall. What type of risk does this represent? A) Diversifiable risk B) Systematic risk C) Political and regulatory risk D) Both B and C Answer: A Topic: Risk 56) As the number of stocks in your portfolio increases A) the variability in your portfolio increases. B) the systematic risk in your portfolio increases. C) the unsystematic risk in your portfolio increases. D) none of the above. Topic: Risk 57) What are the benefits of a well-diversified portfolio? A) It protects you from systematic risk. B) It protects you from firm specific risk. C) It protects you from company-unique risk. D) All of the above are correct. E) All but A are correct. Answer: E Topic: Risk 25

26 58) Examples of political and regulatory risk include A) changes in the tax deductibility of interest on municipal bonds. B) changes in the capital gains tax rate. C) changes in the exchange rates. D) All of the above are correct. E) Only A and B are correct. Answer: E Topic: Risk 59) Hostess and Kodak recently filed for bankruptcy protection in an attempt to restructure their debts. One could assume that both of these companies experienced too much risk. A) business B) interest rate C) financial D) liquidity Answer: C Topic: Risk 60) During the economic downturn that occurred between the fall of 2007 and spring of 2009, stocks declined in price. This period is known as a(n) A) hare market. B) tortoise market. C) bull market. D) bear market. Topic: Risk AACSB: Reflective Thinking 61) Principle #2: the time value of money tells us that time is our greatest ally. This being so, the most important and most difficult step is making the commitment to get started. Tell how to find the money and get started with Principle #15: just do it. Answer: Pay yourself first instead of last; that is, before spending for bills and life's necessities. Making an automatic deposit directly from your paycheck or checking account makes it less painful because you do not see this money first. Take advantage of your employer's matching funds retirement plans and the government's tax reductions, such as IRAs. Use windfalls for investing instead of spending them. If you are having trouble getting started, pick two months per year to cut back on spending and make those your investing months. Topic: Time Value of Money AACSB: Reflective Thinking 26

27 62) Provide an explanation of the four points of making a comparison of investing returns on an after-tax basis. Answer: The tax rate we should be concerned with is the marginal tax rate, because it is the rate we pay on the next dollar of earnings. Check out tax-free investments, which become more attractive as your marginal tax bracket increases. Investigate investments made on a tax-deferred basis, which means the investment grows free of taxes until you liquidate the investment. Topic: Returns 63) How do interest rates affect returns on other investments? Answer: The expected returns on all investments are related. What you earn on one investment determines what you demand on another. When interest rates go up, investors demand a higher return on all other investments, and when interest rates go down, the return investors demand on other investments goes down. In effect, all the different investments compete for your investment dollars, and when interest rates go up, the other investments have to match that increase. Topic: Returns 64) The nominal return on an investment is an illusion. Explain. Answer: An illusion is something that is different than what it appears to be. The nominal return is an illusion because it inflates the nominal or face value of your money possibly without actually increasing your purchasing power of your money. The real return adjusts for the impact of inflation on your ability to purchased goods and services. The key to investing is to increase your standard of living to allow you to maintain or increase the quantity of goods and services that you desire. Negative real returns that do not exceed the rate of inflation means that your purchasing power has diminished, lowering your standard of living. Over the long term, this can seriously interfere with your retirement plans. Young people need to be very aware of the impact of inflation and not to be too conservative with their longer term investments. Topic: Returns 65) Clarify the difference between systematic and unsystematic risk. Answer: Systematic risk is that portion of a security's risk or variability that cannot be eliminated through investor diversification, in other words, that is part of the entire market system. (This explanation might help student remember what is "systematic."). This type of variability or risk results from factors that affect all securities. Unsystematic risk is the risk or variability that can be eliminated through investor diversification. Unsystematic risk results from factors that are unique to a particular firm. Topic: Risk 27

28 66) How does the principle of diversification work? iversification eliminates risk by investing in different assets instead of one. It works by allowing the extreme good and bad returns to cancel each other out. The result is that total variability or risk is reduced without affecting expected return. Topic: Diversification 67) Describe the sources of risk in the risk-return trade off. Answer: The interest rate risk is the risk of fluctuations in security prices due to changes in the market interest rate. Inflation risk reflects the likelihood that rising prices will eat away the purchasing power of your money, and that changes in the anticipated level of inflation will result in interest rate changes, which will in turn cause security price fluctuations. The business risk deals with fluctuations in investment value that are caused by good or bad management decisions, or how well or poorly the firm's products are doing in the marketplace. Financial risk is associated with the use of debt by the firm. How a firm raises and uses its money affects its level of risk. Liquidity risk deals with the inability to liquidate, or convert into cash, quickly a security at a fair market price. Market risk is risk associated with the overall market movements - upward and downward. Political and regulatory risk comes from laws imposed by state and national governments that affect investment values. The exchange rate risk refers to the variability in earnings resulting from changes in exchange rates among countries. Call risk is the risk to bondholders that a bond may be called away from them before maturity, resulting in a loss of income or market value. All of these types of risk make up the risk found in the risk-return trade off. Topic: Risk 68) Rank the historical rates of return of the common investments discussed in this chapter from highest to lowest. Answer: 1. Common stocks 2. Long-term corporate bonds 3. Long-term government bonds 4. Treasury bills Topic: Returns 28

29 69) What makes up the interest rate risk? Answer: The inflation risk premium is the rate in addition to the real rate of return that investors demand to compensate for anticipated inflation over the life of a security. Interest rate risk also includes the default risk premium or an additional investment return to compensate investors for taking on the risk that the issuer may not pay the interest or principal on a security. A third factor is the maturity risk premium, which is an additional return demanded by investors in longer-term securities to compensate for the fact that the value of securities with longer maturities tends to fluctuate more when interest rates change. The liquidity risk premium reflects the risk that some bonds cannot be converted into cash quickly at a fair market price. Topic: Risk 70) Why do investors sometimes demand risk premiums when investing? Answer: The typical investor is risk averse which means they don't like to take risks with their important money like retirement savings. The problem is that conservative, low risk investments typically do not provide a high enough real return to allow these risk averse investors to reach their goals. In order to motivate these investors to assume a higher level of risk, then there must be a higher potential return available. The various risk premiums increase the potential nominal returns providing motivation for investors to assume higher risks. Without these risk premiums no one would be willing to assume the risks inherent with entrepreneurial activities severely limiting access to financial capital needed for business investment. Topic: Risk Premiums 71) Explain the concept of liquidity relating to personal financial planning. Answer: Part of the risk-return tradeoff is the concept of liquidity. With our emergency fund, we can't afford the risk of having our money tied up in an illiquid investment in case we experience an emergency. Since we need to have quick access to our funds, we must accept the lower returns associated with liquid assets. Unfortunately these liquid investments offer low returns because they don't include the liquidity risk premium. With our longer term monies outside of our emergency fund, we can afford to give up liquidity for the extra returns. It may take us months or more to be able to liquidate the investments but since we most likely don't need the money in a hurry, we generally have choices. The main purpose of the emergency fund is to protect us from having to liquidate other investments, possibly at an unfavorable price or terms. Topic: Risk 29

30 11.3 The Time Dimension of Investing and Asset Allocation 1) As the length of your investment horizon increases, you can assume greater risks with your investing. Topic: Time Dimension of Investing 2) Liquidity risk is a very important part of the time dimension of investing. Topic: Time Dimension of Investing 3) A young investor who is averse to risk should invest their money in government bonds. Topic: Asset Allocation 4) A typical young investor should have most of their retirement money allocated in common stocks. Topic: Asset Allocation 5) Because Nancy is extremely risk averse she is less likely to receive a solid rate of return on her investment portfolio than Babby who is more accepting of a risky portfolio. Topic: Time Dimension of Investing 6) A 60-year-old investor should not be too concerned about liquidity and market risk in their retirement portfolio. Topic: Time Dimension of Investing 30

31 7) Typically, the closer you get to retirement, the smaller the proportion of your retirement funds that should be invested in common stocks. Topic: Time Dimension of Investing 8) The concept of asset allocation has nothing to do with the time dimension of investing. Topic: Asset Allocation 9) A catastrophic loss is less critical to an older investor than it is to a younger investor since younger investors typically have less money to lose. Topic: Time Dimension of Investing 10) Asset allocation and diversification are not related concepts. Topic: Asset Allocation 11) Which of the following statements is not true of asset allocation? A) Investments are spread across several different investment classes. B) Investments reflect the investor's specific time horizon. C) Allocation may be made in domestic stocks and bonds. D) Allocation may be made in international stocks and bonds. E) All of the above statements are true. Answer: E Topic: Asset Allocation 31

32 12) Asset allocation has to do with how your money should be divided among which of the following? A) Stocks B) Corporate bonds C) Government bonds D) Real estate E) All of the above Answer: E Topic: Asset Allocation 13) For individuals in their golden years who are approaching retirement, a mix of percent common stocks and percent bonds is a relatively common recommendation from financial planners. A) 20, 80 B) 80, 20 C) 40, 60 D) 60, 40 E) none of the above Topic: Stocks 14) Investing prior to age 54 is a time of by investing the majority of one's savings into. A) wealth preservation; conservative funds B) wealth preservation; preferred stocks C) wealth accumulation; common stocks D) wealth accumulation; bonds E) wealth dispersal; common and preferred stocks Answer: C Topic: Asset Allocation 15) As a young college graduate, your biggest investment ally is A) leverage. B) the amount of investment. C) tax-free investments. D) time. E) the class of investments. Topic: Investment 32

33 16) Cretia Robritti discovered that the purpose of asset allocation is to ensure that the investor is, generally with holdings in several different of investments. A) protected; denominations B) well diversified; amounts C) well diversified; classes D) evenly distributed; classes E) evenly distributed; amounts Answer: C Topic: Asset Allocation 17) Principle 8, Risk and Return go hand in hand, tells us that you as the length of the investment horizon. A) can afford to take on additional risk; increases B) can afford to take on additional risk; decreases C) cannot afford not to take on additional risk; shortens D) cannot afford to take on additional risk; increases Answer: A Topic: Risk 18) Why should a younger investor, saving for the long term, have most of their money in common stocks? A) Over time, common stocks generate the largest average returns. B) Investors with lots of time ahead of them have the opportunity to recover from a serious investment set-back. C) They require the least amount of knowledge, research and expense. D) All of the above are correct. E) Only A and B are correct. Answer: E Topic: Asset Allocation 33

34 19) Why should investors with a short investment horizon invest less money in common stocks? A) Because the stock market is very volatile and a catastrophic market event can happen at any time. B) Because the investors won't have enough time available to effectively recover from a loss of their investment principle. C) Because the transaction costs will negatively affect their returns in the short-term. D) All of the above are correct. E) Only A and B are correct. Answer: E Topic: Time Dimension of Investing 20) What does an effective asset allocation strategy provide to an investor? A) An effective diversification strategy B) An opportunity to maximize their returns based on appropriate risk. C) An opportunity to minimize their losses based on appropriate risk. D) All of the above are correct E) All but A are correct. Topic: Asset Allocation 21) Is it possible to both accumulate wealth and preserve wealth with the same asset allocation strategy? A) Yes, a well-constructed portfolio can achieve both goals effectively. B) No, there are conflicting risks that are contrary to achieving both goals with the same asset classes. C) Yes, a diversified bond portfolio is appropriate for all investors. D) No, a diversified stock portfolio is too risky for the typical young investor. Topic: Asset Allocation 22) Which of the following statements regarding risk in investing is most correct? A) Avoiding risk is the best strategy to accumulate wealth. B) It is most important to avoid risk during the early years, up to age 54. C) It is hard to achieve a positive real return by avoiding risk all together. D) Trying to avoid risk is an exercise in futility. Answer: C Topic: Risk 34

35 23) Provide an explanation for the concept of asset allocation in investing and differentiate between the 3 stages. Answer: Asset allocation attempts to ensure that the investor is well diversified, generally with holdings in several different classes of investments, with the objective being to increase your return on those investments while decreasing your risk. The idea of the time dimension of risk is taken into account by recognizing that common stocks are much less risky over a longer time horizon. Stage 1 is a time of wealth accumulation through age 54. Because the time horizon is long, investments with higher returns and risks should be sought, especially common stocks, to grow into large sums by retirement. Stage 2 consists of the golden years approaching retirement, ages 55 to 64. Here the goal becomes preserving the level of wealth that has already been accumulated and to allow this wealth to continue to grow. Move some of the portfolio, up to 40%, from common stocks into bonds. Stage 3 is the retirement years over age 65 when you are no longer saving, you are spending. Income is now of paramount importance. Allow for some growth in savings simply to keep inflation from devouring your accumulation. Topic: Asset Allocation 24) How does the time dimension of investing relate to the concept of liquidity? Answer: Liquidity concerns the ability to liquidate an asset for a fair market price in a reasonable amount of time. The time dimension of investing means that having sufficient time available until you need your funds allows you invest in less liquid assets that generally have a higher return. The stock market is very volatile and it is common for there to be severe market downturns from time to time. To someone who needs their money now, they would not want to have to liquidate while the market value of their stocks has plummeted, causing them a serious financial loss. Historically, the markets will recover and investors who were not forced to liquidate at the lower market values will recover most if not all of their capital. For a younger investor, a severe market downturn represents a tremendous buying opportunity since many good stocks are 'on sale'. To an older investor who is not properly diversified, a severe market downturn could seriously interrupt their retirement goals causing financial stress and anxiety. Topic: Asset Allocation 11.4 What You Should Know About Efficient Markets 1) It is very tough to consistently beat the market. Topic: Efficient Market 35

36 2) On average, just by chance, half of the stock market's investors will outperform the market and half will underperform the market. Topic: Efficient Market 3) The more efficient the market, the faster prices react to new information. Topic: Efficient Market 4) Under the risk aversion effect, investors who lose money are more reluctant to take risks. Topic: Efficient Market 5) The herd behavior effect involves the emotions of fearing regret and seeking pride, resulting in selling winners too soon and keeping losers too long. Topic: Efficient Market 6) If you earned a negative 5% return on your investments while the overall stock market was down 9% then you have outperformed the market. Topic: Efficient Market 7) An efficient market is one in which all relevant information about the stock is reflected in the stock price. Topic: Efficient Market 8) In trying to "time the market" investors are just as likely to miss out on upswings in the market as well as avoid down turns. Topic: Efficient Market 36

37 9) Because it's difficult to beat the market, make sure you don't give away too much of your return in the way of commissions. Topic: Efficient Market 10) When a stock price reflects all relevant information about the stock, the market is said to be A) efficient. B) fractioned. C) smooth. D) flat. E) none of the above. Answer: A Topic: Efficient Market 11) The disposition effect involves A) holding onto winners too long. B) selling losers too soon. C) both A and B. D) neither A nor B. Topic: Efficient Market 12) Our study of efficient markets tells us all of the following about investing except A) do not try to time the market stay with your plan. B) long-term investing is your best bet, not systems. C) go with the best investment advisor money can buy. D) focus on effective asset allocation. E) diversify and seek help if you don't feel comfortable. Answer: C Topic: Efficient Market 37

38 13) Anthony Hopkins wants to start investing and desires to consistently beat the market. What will you tell him? A) It can be done regularly by a skilled investor. B) It is very tough to do so. C) Half the time you should outperform the market. D) Half the time you should underperform the market. E) All of the above except A Answer: E Topic: Efficient Market 14) Greg spent the weekend in Las Vegas. He started out with $10,000 and won an additional $5000. Greg was very risky with how he gambled with the $5000 he had won. Greg was exhibiting the effect. A) disposition B) house money C) loss then risk aversion D) Las Vegas E) none of the above Topic: Efficient Market AACSB: Ethical Understanding and Reasoning 15) Herd behavior A) is a kind of self-fulfilling behavior. B) involves emotions of fearing regret and seeking pride. C) is exemplified when investors take higher risks with profits than they would normally take. D) all of the above. Answer: A Topic: Efficient Market AACSB: Ethical Understanding and Reasoning 16) Tell how your understanding of efficient markets helps with investing. Answer: My understanding tells me several things worth knowing, which include: - There is no foolproof system for beating the market; invest for the long-term. - Do not try to time the market to take advantage; stay with your plan. - Focus on the asset allocation process based on your age in the financial life cycle. - Keep down the commissions that are paid to brokers and professionals. - Diversify and seek help if you do not feel comfortable. Topic: Efficient Market 38

39 17) What is an efficient market and can you beat the market? Answer: An efficient market is a market in which all relevant information about stocks is reflected in the stock price. The market is efficient in degrees. There are at times undervalued securities and some people are able to take advantage of them while others lose. It is very tough to consistently beat the market. On average, half the time you should expect to outperform the market, and half the time underperform it. The bottom line here is that you should keep to your plan and invest for the long term. If we try to time the market, we are just as likely to miss an upswing as we are to avoid a downswing. Topic: Efficient Market 11.5 Security Markets 1) An individual selling previously issued shares to another individual is a transaction that would be traded in the primary market. Topic: Primary Markets 2) The Securities Act of 1934 created the SEC to enforce trading laws. Topic: Regulation of Securities Market 3) American Depository Receipts are receipts given by American banks for deposits in foreign countries. Topic: International Markets 4) Stocks of most larger companies trade on the American Stock Exchange, while the stocks of most smaller companies trade on the New York Stock Exchange. Topic: Secondary Markets 5) The New York Stock Exchange and the American Stock Exchange are considered regional stock exchanges. Topic: Secondary Markets 39

40 6) An over-the-counter market has a physical location where trading occurs. Topic: Secondary Markets 7) An initial public offering is the first time the company's stock is traded publicly. Topic: Primary Markets 8) Seasoned new issues are stock offerings by companies that already have common stock traded in the marketplace. Topic: Primary Markets 9) An IPO is the sale of previously issued shares to the general public. Topic: Initial Public Offering 10) A primary market is a market in which new, as opposed to previously issued, securities are traded. Topic: Primary Markets 11) A sale of a security in the primary markets is the only time the issuing company receives the proceeds from the sale. Topic: Primary Markets 12) Firms raise outside financial capital through the sale of stocks in the secondary markets. Topic: Secondary Markets 40

41 13) Stocks are initially sold in the primary markets with the help of an investment banker serving as the underwriter. Topic: Primary Markets 14) A prospectus is an advertisement placed in a newspaper or magazine that provides a listing of the underwriting syndicate involved in the new offering, in addition to basic information on the offering. Topic: Primary Markets 15) An ask on offer price is one at which an individual is willing to sell a security. Topic: Secondary Markets 16) In the over-the-counter market, the individual investor must be physically present to purchase the security over-the-counter. Topic: Secondary Markets 17) Any company can have its securities listed on the NYSE. Topic: Secondary Markets 18) The price at which an individual investor is willing to buy a security is the bid price. Topic: Secondary Markets 19) When an individual investor sells their shares on the OTC, the price at which they are willing to sell is called the bid price. Topic: Secondary Markets 41

42 20) The OTC market is a link-up of dealers, with stringent listing and membership requirements. Topic: Secondary Markets 21) The NASDAQ is the largest electronic stock exchange. Topic: Secondary Markets 22) Churning occurs when a broker engages in excessive trading in a client's security account to generate more commissions for the broker. Topic: Regulation of Securities Market 23) A circuit breaker protects individual investors from losing money on their investments. Topic: Regulation of Securities Market 24) An individual investor should look for a stock broker who will churn their accounts for them. Topic: Regulation of Securities Market 25) Although some bonds are traded on the NYSE, most of the buying and selling of bonds doesn't occur on organized exchanges. Topic: Bonds 42