File: ch01: Understanding Investments Multiple Choice 1. Which of the following is the best definition of wealth? a. b. c. d. the sum of all current and future income the total of all assets and all income the total of assets and income less any liabilities. the sum of current income and the present value of future income. Ans: d Difficulty: Moderate Ref: Establishing a Framework for Investors 2. Gold coins would be classified as: a. b. c. d. real assets indirect assets personal assets financial assets Ans: a Difficulty: Easy Ref: Establishing a Framework for Investors 3. Technically, investments include: a. b. c. d. only financial assets. only marketable assets. financial and real assets that are marketable or non-marketable. only financial and real assets that are marketable. Ans: c Difficulty: Easy Ref: Establishing a Framework for Investors 4. The retirement plans that guarantee retirees a set amount of money each are known as: a. b. c. d. 401(k) plans self-directed plans defined-benefit plans defined-contribution plans Ans: c Difficulty: Moderate Chapter One Understanding Investments 1 month Ref: Establishing a Framework for Investors 5. The investment professionals that arrange the sale of new securities are called: a. b. c. d. arbitragers traders investment bankers specialists Ans: c Difficulty: Moderate Ref: The Importance of Studying Investments 6. Another name for stockbrokers is: a. b. c. d. specialists financial advisors security analysts portfolio managers Ans: b Difficulty: Moderate Ref: The Importance of Studying Investments 7. Investment professionals who take companies public, arrange mergers and acquisitions, and participate in municipal bond issues are : a. b. c. d. registered representatives security analysts investment bankers portfolio managers Ans: c Difficulty: Moderate Ref: The Importance of Studying Investments 8. One reason for the declining importance of pension funds is the: a. b. c. d. decrease in pension benefits for workers. downsizing of U.S. companies large number of conversions into self-directed plans. increasing number of federal regulations that restrict pension fund portfolios. Ans: c Difficulty: Difficult Ref: The Importance of Studying Investments Chapter One Understanding Investments 2 9. Most financial advisors are registered with the Securities and Exchange Commission as: a. b. c. d. registered representatives. registered investment advisors. registered financial planners. registered securities consultants. Ans: b Difficulty: Moderate Ref: The Importance of Studying Investments 10. A Chartered Financial Analyst designation is a (an) a. b. c. SEC-approved and awarded designation. certification of a successful investing record. professional designation awarded for meeting recognized standards of conduct and competency. professional designation awarded by the brokerage industry. d. Ans: c Difficulty: Easy Ref: The Importance of Studying Investments 11. Underlying all investments is the tradeoff between: a. b. c. d. expected return and actual return low risk and high risk actual return and high risk expected return and risk Ans: d Difficulty: Moderate Ref: Understanding the Investment Decision Process 12. Which of the following investment areas is heavily tied to work using mathematical and statistical models? a. b. c. d. Security analysis Portfolio management Institutional investing Retirement planning Ans: b Difficulty: Moderate Ref: Understanding the Investment Decision Process Chapter One Understanding Investments 3 13. Most investors are risk averse which means: a. they will assume more risk only if they are compensated by higher expected return. they will always invest in the investment with the lowest possible risk. they actively seek to minimize their risks. they avoid the stock market due to the high degree of risk. b. c. d. Ans: a Difficulty: Moderate Ref: Understanding the Investment Decision Process 14. Which of the following would be considered a risk-free investment? a. b. c. d. gold equity in a house high-grade corporate bonds U.S. Treasury bills Ans: d Difficulty: Easy Ref: Understanding the Investment Decision Process 15. Security analysis is most concerned with: a. b. c. d. analysis of the overall securities market and its direction. valuation and analysis of individual securities. purchasing securities at the best price. determination of the investor’s required return. Ans: b Difficulty: Moderate Ref: Understanding the Investment Decision Process 16. In general, the ex ante risk-return tradeoff a. b. c. d. slopes upward. slopes downward is flat is impossible to determine. Ans: a Difficulty: Moderate Ref: Understanding the Investment Decision Process 17. International investing: a. is only practical for institutional investors. Chapter One Understanding Investments 4 b. c. d. increases the overall risk of a stock portfolio. always leads to higher returns than a domestic portfolio. can reduce risk due to increased diversification. Ans: d Difficulty: Moderate Ref: Understanding the Investment Decision Process 18. Investment decision making traditionally consists of two steps: a. b. c. d. investment banking and security analysis buying and selling risk and expected return. security analysis and portfolio management. Ans: d Difficulty: difficult Ref: Understanding the Investment Decision Process 19. Which of the following statements concerning global stock market capitalization is true? a. b. c. d. The United States accounts for roughly 85 percent of stock market capitalization worldwide. The United States accounts for roughly 50 percent of stock market capitalization worldwide. The United States accounts for roughly 25 percent of stock market capitalization. It is expected that the United States will increase its percentage of stock market capitalization in the world over time. Ans: b Difficulty: Moderate Ref: Important Considerations in the Investment Decision Process for Today's Investor 20. Regulation FD applies to disclosure between: a. b. c. d. private companies and public officials public companies and investment professionals public companies and public officials private companies and investment professionals Ans: b Difficulty: Moderate Ref: Important Considerations in the Investment Decision Process for Today's Investor 21. Which of the following statements is true regarding multi-national corporations? a. Both Exxon Mobil and Hewlett Packard earn roughly 70% of their profits from their overseas operations. Chapter One Understanding Investments 5 b. c. d. Google currently derives about 95% of its earnings from the U.S. Wal-Mart earns nearly 50% of its profits outside the U.S. Coca-Cola has no overseas operations and no earnings outside the U.S. at all Ans: a Difficulty: difficult Ref: Important Considerations in the Investment Decision Process for Today's Investor 22. The rise of the Internet has: a. b. c. d. greatly increased the cost of security trading. significantly democratized the flow of investment information. led to fewer number of discount brokers led to large amounts of security fraud. Ans: b Difficulty: Moderate Ref: Important Considerations in the Investment Decision Process for Today's Investor 23. Which of the following professionals would be considered an institutional investor? a. b. c. d. Investment Banker Security Analyst Stockbroker Portfolio Manager Ans: d Difficulty: difficult Ref: Important Considerations in the Investment Decision Process for Today's Investor 24. The risk-free rate of return (RFR) equals: a. 3.5% b. the return on long-term Treasury bonds c. the average of the last 3 years’ inflation rate d. the return on short-term Treasury bills Ans: d Difficulty: difficult Ref: Important Considerations in the Investment Decision Process for Today's Investor 25. All of the following are benefits of geographic diversification in investment portfolios EXCEPT: a. b. c. d. Gaining exposure to currencies other than the U.S. dollar. Some global markets have growth rates higher than the U.S., offering potentially higher returns. Global markets behave completely independently of U.S. markets. Many global markets are not highly correlated with U.S. markets. Chapter One Understanding Investments 6 Ans: c Difficulty: difficult Ref: Important Considerations in the Investment Decision Process for Today's Investor True-False Questions 1. A 401(k) plan is an example of a defined benefit retirement plan. Ans: False Difficulty: Moderate Ref: The Importance of Studying Investments 2. Investors always seek to minimize their risk of investing. Ans: False Difficulty: Moderate Ref: Understanding the Investment Decision Process 3. Both 401(k) plans and IRAs are self-directed retirement plans. Ans: True Difficulty: Easy Ref: Understanding the Investment Decision Process 4. The two major considerations in investing are return and timing. Ans: F Difficulty: Easy Ref: Understanding the Investment Decision Process 5. Risk is defined as the possibility of loss. Ans: False Difficulty: difficult Ref: Understanding the Investment Decision Process 6. The minimum actual return necessary to induce investors to invest is known as the expected return. Answer: False Difficulty: difficult Ref: Understanding the Investment Decision Process 7. Investors enjoyed the best 5 consecutive years in the stock market history over the period 1996-2000. Answer: False Chapter One Understanding Investments 7 Difficulty: Moderate Ref: Understanding the Investment Decision Process 8. Investors unwilling to assume risk should be satisfied with the rate of inflation as their investment return. Answer: False Difficulty: difficult Ref: Understanding the Investment Decision Process 9. Security analysts are typically employed only at brokerage houses. Answer: False Difficulty: Moderate Ref: Importance of Studying Investments 10. Financial planners must pass a standardized test and possess certain credentials. Ans: False Difficulty: Easy Ref: Importance of Studying Investments 11. Many Wall Street jobs tend to be cyclical in nature.. Ans: True Difficulty: Easy Ref: Importance of Studying Investments 12. Due to the Internet, institutional investors have gained in importance. Ans: F Difficulty: difficult Ref: Important Considerations in the Investment Decision Process for Today's Investor Short-Answer Questions 1. Briefly explain the difference between expected returns and realized returns and between ex ante returns an ex post returns. Answer: Difficulty: 2. Expected returns are mean returns based on probability distributions dealing with the future. Realized returns are the returns that actually occurred in the past. Ex ante returns are in the future. Ex post returns are in the past. Moderate What are some of the career opportunities in the investment industry? Chapter One Understanding Investments 8 Answer: Difficulty: 3. Define risk in the context of investments? Answer: Difficulty: 4. Investment banker, merger and acquisition specialist, security traders, sales people, security analyst, portfolio manager, registered investment advisor and financial planner. Moderate Risk is the chance that the actual return on an investment will differ from its expected return. Moderate Will risk-averse investors ever include commodity futures or options in their portfolios? Explain. Answer: Difficulty: They may include these items in their portfolios since risk-averse is not the same thing as risk avoidance. Risk-averse investors would expect a higher return from these assets as they are riskier than many other assets. Moderate Martha Stewart was banned from serving as an officer of a public corporation, sentenced to 5 months in prison, and fined $30,000. Why? 5. Answer: Contrary to popular belief, she was not charged with insider trading but obstruction of justice as a result of her efforts to hide her alleged insider trading. Difficulty: Moderate 6. A 25-year old college graduate is participating in a 401(k) retirement plan and wishes to minimize risk by eliminating stock-based mutual funds and other equities from his investment portfolio. What will this probably do to his ending retirement funds in 40 years? Answer: Difficulty: If he minimizes risk, then he will also minimize return. His retirement fund will likely be much smaller than if he chose to take more risk over the long run. Moderate Critical Thinking/Essay Questions 1. What are some of the steps involved in valuing a company’s common stock? Answer: Difficulty: The investor must evaluate the overall economy, industry and individual company, since all have an impact on the value of the stock. In addition, the expected return and appropriate risk must be estimated, based upon the expected future cash flows of the company. And lastly, the efficiency of stock markets must be considered and whether the current market value of the stock is greater or less than its perceived economic value. difficult Chapter One Understanding Investments 9 2. What are some of the reasons driving so many individual investors to manage their own investments today, versus the conventional route of investing through a financial advisor, or stockbroker? Answer: Difficulty: The emergence of the Internet has produced a host of online, discount brokers offering ultra low-cost commissions, sometimes free trades, and real-time quotes on stocks and bonds. There is also now a preponderance of websites offering information on corporate news and SEC filings, which helps investors become more self-sufficient if they so choose. Also, extreme levels of market volatility seen in the last decade have eroded the wealth of many investors, including whatever portion was being professionally managed by mutual funds or through financial advisors. That begs the question of whether professional management or advice is worth the cost in the face of such tremendous wealth erosion. Many investors have decided to go out on their own, using a discount broker. Moderate Chapter One Understanding Investments 10 Files: ch02, Chapter 2: Investment Alternatives Multiple Choice Questions 1. The largest single institutional owner of common stocks is: a. b. c. d. mutual funds. insurance companies. pension funds. commercial banks. Ans: c Difficulty: Moderate Ref: Organizing Financial Assets 2. Which of the following is not a characteristic of the primary nonmarketable financial asset owned by most individuals? a. b. c. d. High liquidity High return Often issued by the U.S. government Low risk Ans: b Difficulty: Moderate Ref: Nonmarketable Financial Assets 3. Savings accounts are: a. b. c. d. negotiable but are not liquid. marketable but are not liquid. liquid but are not personal. liquid but are not marketable. Ans: d Difficulty: Difficult Ref: Nonmarketable Financial Assets 4. Nonmarketable financial assets that protect against inflation include: a. b. c. d. nonnegotiable certificates of deposit (CDs). money market deposit accounts (MMDAs). Series EE US government savings bonds. US government savings bonds, I bonds. Chapter Two Investment Alternatives 10 Ans: d Difficulty: Moderate Ref: Nonmarketable Financial Assets 5. Treasury bills are traded in the: a. b. c. d. money market. capital market. government market. regulated market. Ans: a Difficulty: Easy Ref: Money Market Securities 6. a. b. c. d. Which of the U.S. Treasury securities is always sold at a discount? Treasury bills Treasury notes Treasury bonds Treasury inflation protected securities (TIPS) Ans: a Difficulty: Moderate Ref: Money Market Securities 7. Which of the following statements regarding money market instruments is not true? a. b. c. d. They tend to be highly marketable. They have maturities from 1 to 3 years. They tend to have a low probability of default. Their rates tend to move together. Ans: b Difficulty: Moderate Ref: Money Market Securities 8. Which of the following would not be considered a capital market security? a. b. c. d. A 20-year corporate bond A common stock A 6-month Treasury bill A mutual fund share Ans: c Difficulty: Moderate Ref: Capital Market Securities Chapter Two Investment Alternatives 11 9. The coupon rate is another name for the: a. b. c. d. market interest rate. current yield. stated interest rate. yield to maturity. Ans: c Difficulty: Easy Ref: Fixed-Income Securities 10. Zero-coupon bonds are similar to Treasury bills in that both: a. b. c. d. are issued exclusively by the U.S. Treasury. are money-market securities. are capital-market securities. are sold at less than par. Ans: d Difficulty: Moderate Ref: Fixed-Income Securities 11. Each point on a corporate bond quote represents: a. b. c. d. $100. 1 percent of $100. 1 percent of $1000. $1000. Ans: c Difficulty: Difficult Ref: Fixed-Income Securities 12. Treasury STRIPS are most similar to which type of corporate security? a. b. c. d. Preferred stock Premium bond High-yield bond Zero-coupon bond Ans: d Difficulty: Moderate Ref: Fixed-Income Securities Chapter Two Investment Alternatives 12 13. Bonds trade on an accrual interest basis. This means an investor: a. b. can sell a bond at any time without losing the interest that has accrued. can buy a bond at any time and gain the interest accrued from the time of the last payment. can sell a bond at any time and retain the interest portion of the bond. can buy a bond at any time and receive an immediate interest check. c. d. Ans: a Difficulty: Moderate Ref: Fixed-Income Securities 14. Bonds called in are likely to be: a. b. c. d. bonds already in default. replaced with new bonds that have a lower interest rate. replaced with new bonds that have a higher interest rate. junk bonds. Ans: b Difficulty: Moderate Ref: Fixed-Income Securities 15. What will a bond be worth on the day it matures? a. b. c. d. $0 $100 Its face value (plus remaining coupon, if applicable) Its remaining coupon, if applicable Ans: c Difficulty: Moderate Ref: Fixed-Income Securities 16. Which of the following statements is true regarding an investment in mortgagebacked securities? a. b. c. d. There is little default risk. The stated maturity is generally 10 years. They receive a fixed payment per month. They are not subject to prepayment. Ans: a Difficulty: Moderate Ref: Fixed-Income Securities Chapter Two Investment Alternatives 13 17. A municipal bond issued to finance a toll bridge would most likely be a: a. b. c. d. general obligation bond. revenue bond. special assessment bond. zero-coupon bond. Ans: b Difficulty: Easy Ref: Fixed-Income Securities 18. What is the major difference between municipal bonds and other types of bonds? a. b. c. d. Municipal bonds are always insured; other bonds are not. Unlike other bonds, municipal bonds sell at a discount. Municipal bond interest is tax-exempt; interest on other bonds is not. There is no brokerage commission on municipal bonds unlike other bonds. Ans: c Difficulty: Moderate Ref: Fixed-Income Securities 19. For an investor with a 28% marginal tax rate, what return would a corporate bond have to pay to provide the same after-tax return as a municipal bond paying 5%? a. b. c. d. 1.40% 2.50% 5.00% 6.94% Ans: d Difficulty: Moderate Ref: Fixed-Income Securities 20. Interest on bonds is typically paid: a. b. c. d. monthly. quarterly. semi-annually. annually. Ans: c Difficulty: Moderate Ref: Fixed-Income Securities Chapter Two Investment Alternatives 14 21. Treasury bonds generally have maturities of: a. b. c. d. 5 to 15 years. 5 to 30 years. 10 to 20 years. 10 to 30 years. Ans: d Difficulty: Easy Ref: Fixed-Income Securities 22. A corporate bond with a rating of BBB- is considered to be which of the following? a. b. c. d. Non-investment grade Investment grade Speculative grade Junk or high-yield Ans: b Difficulty: Difficult Ref: Fixed-Income Securities 23. An unsecured bond is known as a(n): a. b. c. d. debenture. indenture. mortgage bond. junk bond. Ans: a Difficulty: Moderate Ref: Fixed-Income Securities 24. Which of the following 10-year bonds would have the lowest yield? a. b. c. d. AAA-rated corporate bond AAA-rated insured municipal bond U.S. Treasury bond AAA-rated mortgage-backed bond Ans: b Difficulty: Difficult Ref: Fixed-Income Securities Chapter Two Investment Alternatives 15 25. For U.S. companies, dividends are typically paid: a. b. c. d. monthly. quarterly. semi-annually. yearly. Ans: b Difficulty: Easy Ref: Equity Securities 26. If an investor states that Intel is overvalued at 65 times, he is referring to Intel’s: a. b. c. d. earnings per share. dividend yield. book value. P/E ratio. Ans: d Difficulty: Difficult Ref: Equity Securities 27. Which of the following is a security that represents shares of a foreign company, which are held in a bank? a. b. c. d. Convertible bond American Depository Receipt (ADR) Asset-backed security LEAPS Ans: b Difficulty: Easy Ref: Equity Securities 28. Which of the following statements regarding common stocks is true? a. b. c. d. The par value of common stock is usually $100. The market value of common stock is equal to its book value. Dividends on common stock are at the discretion of the company. Common stock has a senior claim on company assets. Ans: c Difficulty: Moderate Ref: Equity Securities Chapter Two Investment Alternatives 16 29. If a preferred stock issue is cumulative, this means: a. b. c. unpaid preferred stock dividends are paid at the end of the year. unpaid preferred stock dividends are legally binding on the corporation. unpaid preferred stock dividends must be paid in the future before common stock dividends can be paid. unpaid preferred stock dividends are never repaid. d. Ans: c Difficulty: Moderate Ref: Equity Securities 30. Which of the following statements is true regarding asset-backed securities? a. b. c. d. They offer relatively high yields. They have relatively long maturities. They generally have low credit ratings. Each traunche has the same risk. Ans: a Difficulty: Moderate Ref: Asset Backed Securities 31. What is the biggest difference between an option and a futures contract? a. b. c. Options are traded on exchanges, whereas futures are not. Options give investors a way to manage portfolio risk, while futures do not. Options can be used by speculators to profit from price fluctuations, while futures cannot. Options give their holders the right to buy or sell, whereas futures contracts are obligations to buy or sell. d. Ans: d Difficulty: Difficult Ref: Derivative Securities 32. The premium on an option is the: a. b. c. d. par value of the option. price of the option. book value of the option. price at which a security may be bought or sold using the option. Ans: b Difficulty: Moderate Ref: Derivative Securities Chapter Two Investment Alternatives 17 33. If a call option has a $10 strike price, and the underlying stock is trading at $11, then the option is considered: a. b. c. d. in the money. at the money. out of the money. worthless. Ans: a Difficulty: Easy Ref: Derivative Securities True-False Questions 1. Direct investing involves trades made by directly purchasing shares of a financial intermediary. Ans: False Difficulty: Moderate Ref: Organizing Financial Assets 2. An example of indirect investing would be buying shares in a mutual fund. Ans: True Difficulty: Easy Ref: Organizing Financial Assets 3. Nonmarketable investments would include savings accounts at banks and Treasury bills. Ans: False Difficulty: Moderate Ref: Nonmarketable Financial Assets 4. Marketable securities all fall into the category of capital market securities. Ans: False Difficulty: Moderate Ref: Nonmarketable Financial Assets 5. All U. S. government securities are considered marketable securities. Ans: False Difficulty: Easy Ref: Money Market Securities Chapter Two Investment Alternatives 18 6. Money market securities generally carry a low chance of default. Ans: True Difficulty: Moderate Ref: Money Market Securities 7. The money market rate most often used as a benchmark for the risk-free rate is the money market deposit account rate. Ans: False Difficulty: Easy Ref: Money Market Securities 8. The rate spreads between the different money market securities of the same term tend to be quite large. Ans: False Difficulty: Difficult Ref: Money Market Securities 9. Treasury notes represent the nontraded debt of the U.S. government. Ans: False Difficulty: Moderate Ref: Fixed-Income Securities 10. The capital market includes both fixed-income and equity securities. Ans: True Difficulty: Easy Ref: Fixed-Income Securities 11. Term bonds have a single maturity. Ans: True Difficulty: Easy Ref: Fixed-Income Securities 12. The return on a zero-coupon bond is derived from the difference between the purchase price of the bond and its par value. Ans: True Difficulty: Difficult Ref: Fixed-Income Securities Chapter Two Investment Alternatives 19 13. The deeper the discount on a zero-coupon bond, the lower the effective return. Ans: False Difficulty: Moderate Ref: Fixed-Income Securities 14. If a bond has a coupon greater than the current market yield, it should be selling at a premium. Ans: True Difficulty: Difficult Ref: Fixed-Income Securities 15. Callable bonds attract investors because they can be redeemed early. Ans: False Difficulty: Moderate Ref: Fixed-Income Securities 16. TIPS adjust for inflation by adjusting the rate of interest paid on the bond. Ans: False Difficulty: Difficult Ref: Fixed-Income Securities 17. The major attraction of municipal bonds is their extremely low risk. Ans: False Difficulty: Moderate Ref: Fixed-Income Securities 18. Investors in high tax brackets would be unlikely to invest in municipal bonds. Ans: False Difficulty: Moderate Ref: Fixed-Income Securities 19. In the case of a corporate bankruptcy, bondholders are paid before any distributions are paid to preferred or common stockholders. Ans: True Difficulty: Moderate Ref: Fixed-Income Securities 20. Bond ratings are primarily used to assess interest rate risk. Ans: False Difficulty: Moderate Ref: Fixed-Income Securities Chapter Two Investment Alternatives 20 21. The major bond rating service is Dun & Bradstreet. Ans: False Difficulty: Easy Ref: Fixed-Income Securities 22. The earnings retention rate is calculated as 1 – dividend yield. Ans: False Difficulty: Easy Ref: Equity Securities 23. The par value on common stock sets the value that stockholders will receive in case of bankruptcy. Ans: False Difficulty: Easy Ref: Equity Securities 24. LEAPS have maturity dates up to 10 years. Ans: False Difficulty: Easy Ref: Equity Securities 25. Most futures contracts are not exercised. Ans: T Difficulty: Moderate Ref: Equity Securities 26. Convertible bonds give their investors the right to convert the bond into common stock at their discretion. Ans: True Difficulty: Easy Ref: Fixed-Income Securities Short-Answer Questions 1. Distinguish between direct and indirect investing. Answer: Difficulty: Ref: Direct investing – buy bonds and stocks; Indirect investing – buy mutual funds, contribute to pension plans, buy life insurance policies. Easy Organizing Financial Assets Chapter Two Investment Alternatives 21 2. Compare the cash flows an investor expects from coupon bonds, zero-coupon bonds, and preferred stock. Answer: Difficulty: Ref: 3. How is the earnings retention rate related to the dividend payout rate? Answer: Difficulty: Ref: 4. Difficulty: Ref: Difficulty: Ref: If a stock is trading at 12 times earnings, it is cheaper than the one trading at 20 times earnings in the sense investors get $1 of earnings for only a $12 investment in buying the stock. Moderate Equity Securities What are two direct and one indirect method for individuals to invest in foreign stocks? Answer: Difficulty: Ref: 7. Stock splits do not affect total value of equity or the individual accounts, other than the number of shares outstanding and the par value. Moderate Equity Securities In what sense is a stock selling for 12 times earnings “cheaper” than a stock with a P/E ratio of 20? Answer: 6. Earnings retention rate = 1 - dividend payout rate Moderate Equity Securities How is the total book value of equity affected by stock splits? Answer: 5. Coupon bonds – annuity of interest payments plus lump sum of principal at maturity Zero-coupon bonds – principal at maturity Preferred stock – annuity ad infinitum (perpetuity) Moderate Fixed-Income Securities Buy securities directly through exchanges or as American depository receipts and indirectly through mutual funds. Moderate Organizing Financial Assets, Equity Securities Explain how writing option contracts (both puts and calls) can generate income for owners of the underlying stock. Answer: Difficulty: Ref: The writer keeps the option premium regardless of whether or not the option is exercised. Moderate Derivative Securities Chapter Two Investment Alternatives 22 8. Rank (lowest to highest) the following securities in terms of the risk-expected return tradeoff from the investors’ viewpoint: common stock, corporate bonds, U.S. Treasury bonds, preferred stock. Answer: Difficulty: Ref: 9. What are some advantages of asset-backed securities to investors? Answer: Difficulty: Ref: 10. U.S. Treasury bonds, corporate bonds, preferred stock, common stock Moderate Fixed-Income Securities, Equity Securities High yields with manageable risk. Moderate Fixed-Income Securities Who benefits from a futures contract, a call contract, and a put contract, if prices fall? Answer: Difficult: Ref: The seller of the futures contract, the writer of the call contract, and the buyer of the put contract. Moderate Derivative Securities Essay Questions 1. Does the options market help stabilize or destabilize the stock market? Explain. Answer: Difficulty: Ref: 2. Options should be a stabilizing force if options are used to hedge stock positions. Options might be destabilizing if used for speculation. Difficult Equity Securities, Derivative Securities How do asset-backed securities improve the flow of funds from savers to borrowers? Answer: Difficulty: Ref: Asset-backed securities can be sold to a broader market of investors than the underlying securities. Moderate Fixed-Income Securities Problems 1. What rate would a taxable corporate bond have to pay to be comparable to a municipal bond with a coupon rate of 7 percent if the investor is in the 28 percent tax bracket? Answer: Difficulty: Ref: Taxable equivalent yield is 0.07/(1-0.28) = 9.72% Easy Fixed-Income Securities Chapter Two Investment Alternatives 23 2. A corporate investor in the 34% marginal income tax bracket can buy bonds issued by a petroleum exploration company yielding 10.606%. The investor should be willing to buy tax-exempt municipal bonds of similar quality yielding what percent or higher? Answer: Difficulty: Ref: 3. The par value of Blaze, Inc. common stock is $0.50, the earnings per share is $4, the stock price is $60, and the dividend per share is $1. Calculate the dividend yield. Answer: Difficulty: Ref: 4. Dividend yield = $1/$60 = 0.0167 = 1.67% Moderate Equity Securities The par value of Blaze, Inc. common stock is $0.50, the earnings per share is $4, the stock price is $60, and the dividend per share is $1. Calculate the payout ratio. Answer: Difficulty: Ref: 5. 10.606 x (1.0-0.34) = 7.00 percent Easy Fixed-Income Securities Payout rate = $1/$4 = 0.25 = 25% Moderate Equity Securities The par value of Inferno, Inc. common stock is $0.50, the earnings per share is $6, and it trades at a P/E of 15. What is Inferno, Inc.’s stock price? Answer: Difficulty: Ref: Stock price is EPS x P/E = $6 x 15 = $90 Moderate Equity Securities Chapter Two Investment Alternatives 24