# P2.T8. Investment Management

Practice questions for investment management and risk management

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1. ### Question 54: Shareholders

Question: According to Stulz, management compensation helps to overcome the agency problem. In his view, which incentive compensation vehicle would MOST EFFECTIVELY align managers with shareholders? A. Grants (awards) of restricted stock B. Grants (awards) of stock options C. Cash incentive plans linked to controllable metrics D. Managers purchase stock at a discount Answer: D ...
Question: According to Stulz, management compensation helps to overcome the agency problem. In his view, which incentive compensation vehicle would MOST EFFECTIVELY align managers with shareholders? A. Grants (awards) of restricted stock B. Grants (awards) of stock options C. Cash incentive plans linked to controllable metrics D. Managers purchase stock at a discount Answer: D ...
Question: According to Stulz, management compensation helps to overcome the agency problem. In his view, which incentive compensation vehicle would MOST EFFECTIVELY align managers with shareholders? A. Grants (awards) of restricted stock B. Grants (awards) of stock options C. Cash incentive...
Question: According to Stulz, management compensation helps to overcome the agency problem. In his view, which incentive compensation vehicle would MOST EFFECTIVELY align managers with...
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2. ### Question 53: Risk

Question: A small diversified shareholder is indifferent to which risk that a large undiversified shareholder does indeed care about? A. Systematic risk B. Financial distress C. Leverage D. Diversifiable risk Answer: D Explanation: A small diversified shareholder will not reward a company for reducing diversifiable (or firm-specific) risk . This is a key implication of the CAPM:...
Question: A small diversified shareholder is indifferent to which risk that a large undiversified shareholder does indeed care about? A. Systematic risk B. Financial distress C. Leverage D. Diversifiable risk Answer: D Explanation: A small diversified shareholder will not reward a company for reducing diversifiable (or firm-specific) risk . This is a key implication of the CAPM:...
Question: A small diversified shareholder is indifferent to which risk that a large undiversified shareholder does indeed care about? A. Systematic risk B. Financial distress C. Leverage D. Diversifiable risk Answer: D Explanation: A small diversified shareholder will not reward a...
Question: A small diversified shareholder is indifferent to which risk that a large undiversified shareholder does indeed care about? A. Systematic risk B. Financial distress C. Leverage D....
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3. ### Question 52: Optimal capital structure

Question: The optimal capital structure strikes a balance between which two costly extremes? A. Cost of equity and cost of financial distress B. Cost of debt and cost of financial distress C. Cost of equity and cost of debt D. Cost of debt and cost of tax shield Answer: A Explanation: At the one extreme is 100% equity-financed company. Equity is more costly than debt, so this firm...
Question: The optimal capital structure strikes a balance between which two costly extremes? A. Cost of equity and cost of financial distress B. Cost of debt and cost of financial distress C. Cost of equity and cost of debt D. Cost of debt and cost of tax shield Answer: A Explanation: At the one extreme is 100% equity-financed company. Equity is more costly than debt, so this firm...
Question: The optimal capital structure strikes a balance between which two costly extremes? A. Cost of equity and cost of financial distress B. Cost of debt and cost of financial distress C. Cost of equity and cost of debt D. Cost of debt and cost of tax shield Answer: A ...
Question: The optimal capital structure strikes a balance between which two costly extremes? A. Cost of equity and cost of financial distress B. Cost of debt and cost of financial distress C....
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4. ### Question 51: After-tax income

Question: A company is 100% equity financed and will next year generate pretax income (EBIT) of $100 million. The company's tax rate is 40%. The company issues a$100 million long-term bond that pays interest annually at 10%. How much will the after-tax income be reduced (i.e., aftertax income without debt minus aftertax income with debt)? A. 0 B. $4 million C.$6 million D. $10 million ... Question: A company is 100% equity financed and will next year generate pretax income (EBIT) of$100 million. The company's tax rate is 40%. The company issues a $100 million long-term bond that pays interest annually at 10%. How much will the after-tax income be reduced (i.e., aftertax income without debt minus aftertax income with debt)? A. 0 B.$4 million C. $6 million D.$10 million ...
Question: A company is 100% equity financed and will next year generate pretax income (EBIT) of $100 million. The company's tax rate is 40%. The company issues a$100 million long-term bond that pays interest annually at 10%. How much will the after-tax income be reduced (i.e., aftertax income...
Question: A company is 100% equity financed and will next year generate pretax income (EBIT) of $100 million. The company's tax rate is 40%. The company issues a$100 million long-term bond that...
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5. ### Question 50: Financial distress

Question: The costs of financial distress include each of the following EXCEPT: A. Opportunity cost of not investing in growth projects B. Distracted management C. Customer reluctance to deal with distressed firm D. Cost of risk management program(s) Answer: D Explanation: Strictly speaking, the cost of risk management programs are incurred in order to reduce the cost of financial...
Question: The costs of financial distress include each of the following EXCEPT: A. Opportunity cost of not investing in growth projects B. Distracted management C. Customer reluctance to deal with distressed firm D. Cost of risk management program(s) Answer: D Explanation: Strictly speaking, the cost of risk management programs are incurred in order to reduce the cost of financial...
Question: The costs of financial distress include each of the following EXCEPT: A. Opportunity cost of not investing in growth projects B. Distracted management C. Customer reluctance to deal with distressed firm D. Cost of risk management program(s) Answer: D Explanation: Strictly...
Question: The costs of financial distress include each of the following EXCEPT: A. Opportunity cost of not investing in growth projects B. Distracted management C. Customer reluctance to deal...
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6. ### Question 49: Arbitrage profit

Question: Assume a gold-producing firm that produces a fixed quantity of gold; the only uncertainty is the price of gold. Further assume the gold-producing firm can hedge its gold price exposure. If the firm can do this, and if the hedged firm value is greater than the unhedged firm value, how is an arbitrage profit possible? A. Short unhedged firm, short gold futures, buy hedged firm B....
Question: Assume a gold-producing firm that produces a fixed quantity of gold; the only uncertainty is the price of gold. Further assume the gold-producing firm can hedge its gold price exposure. If the firm can do this, and if the hedged firm value is greater than the unhedged firm value, how is an arbitrage profit possible? A. Short unhedged firm, short gold futures, buy hedged firm B....
Question: Assume a gold-producing firm that produces a fixed quantity of gold; the only uncertainty is the price of gold. Further assume the gold-producing firm can hedge its gold price exposure. If the firm can do this, and if the hedged firm value is greater than the unhedged firm value, how...
Question: Assume a gold-producing firm that produces a fixed quantity of gold; the only uncertainty is the price of gold. Further assume the gold-producing firm can hedge its gold price exposure....
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7. ### Question 48: Systematic risk

Question: Under what condition will reduction of the firm's systematic risk create firm value? A. Never B. Firm's beta is greater than one C. Firm's systematic risk greater than implied by CAPM D. Cost to reduce less than external cost to bear risk Answer: D Explanation: Answer (A) is not bad. The default assumption is that reducing systematic risk does not create firm value. The...
Question: Under what condition will reduction of the firm's systematic risk create firm value? A. Never B. Firm's beta is greater than one C. Firm's systematic risk greater than implied by CAPM D. Cost to reduce less than external cost to bear risk Answer: D Explanation: Answer (A) is not bad. The default assumption is that reducing systematic risk does not create firm value. The...
Question: Under what condition will reduction of the firm's systematic risk create firm value? A. Never B. Firm's beta is greater than one C. Firm's systematic risk greater than implied by CAPM D. Cost to reduce less than external cost to bear risk Answer: D Explanation: Answer (A)...
Question: Under what condition will reduction of the firm's systematic risk create firm value? A. Never B. Firm's beta is greater than one C. Firm's systematic risk greater than implied by...
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8. ### Question 47: Continuous compounding

Question: Assume a firm will generate $100 million at the end of the year, its only cash flow (like the gold mining company in the Stulz reading, the firm then liquidates). The risk-free rate is 4% and the equity (market) risk premium is 4%. The firm's beta is 1.5. But the firm can spend$1 million to reduce its risk. In the first scenario, this spending reduces (only and entirely) the firm's...
Question: Assume a firm will generate $100 million at the end of the year, its only cash flow (like the gold mining company in the Stulz reading, the firm then liquidates). The risk-free rate is 4% and the equity (market) risk premium is 4%. The firm's beta is 1.5. But the firm can spend$1 million to reduce its risk. In the first scenario, this spending reduces (only and entirely) the firm's...
Question: Assume a firm will generate $100 million at the end of the year, its only cash flow (like the gold mining company in the Stulz reading, the firm then liquidates). The risk-free rate is 4% and the equity (market) risk premium is 4%. The firm's beta is 1.5. But the firm can spend$1...
Question: Assume a firm will generate \$100 million at the end of the year, its only cash flow (like the gold mining company in the Stulz reading, the firm then liquidates). The risk-free rate is...
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9. ### Question 46: Market efficiency

Question: In regard to the three forms of market efficiency, what is the key difference between (i) weak and semi-strong and (ii) semi-strong and strong? A. Past Prices. Public information. B. Private information. Public information. C. Public information. Private information D. Private information. Past prices. Answer: C Explanation: The three forms are (1) Weak efficiency:...
Question: In regard to the three forms of market efficiency, what is the key difference between (i) weak and semi-strong and (ii) semi-strong and strong? A. Past Prices. Public information. B. Private information. Public information. C. Public information. Private information D. Private information. Past prices. Answer: C Explanation: The three forms are (1) Weak efficiency:...
Question: In regard to the three forms of market efficiency, what is the key difference between (i) weak and semi-strong and (ii) semi-strong and strong? A. Past Prices. Public information. B. Private information. Public information. C. Public information. Private information D. Private...
Question: In regard to the three forms of market efficiency, what is the key difference between (i) weak and semi-strong and (ii) semi-strong and strong? A. Past Prices. Public information. B....
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10. ### Question 45: Validity of equilibrium

Question: Roll's criticism undermines the validity of equilibrium theory by asserting which of the following: A. Market portfolio cannot be observed B. Assets have different betas C. True riskless asset does not exist D. Lack of transaction costs, taxes is unrealistic Answer: A Explanation: Regarding (C), Black's zero beta-beta model was developed to address (1) whether the...
Question: Roll's criticism undermines the validity of equilibrium theory by asserting which of the following: A. Market portfolio cannot be observed B. Assets have different betas C. True riskless asset does not exist D. Lack of transaction costs, taxes is unrealistic Answer: A Explanation: Regarding (C), Black's zero beta-beta model was developed to address (1) whether the...
Question: Roll's criticism undermines the validity of equilibrium theory by asserting which of the following: A. Market portfolio cannot be observed B. Assets have different betas C. True riskless asset does not exist D. Lack of transaction costs, taxes is unrealistic Answer: A ...
Question: Roll's criticism undermines the validity of equilibrium theory by asserting which of the following: A. Market portfolio cannot be observed B. Assets have different betas C. True...
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11. ### Question 44: CAPM

Question: Which of the following is NOT an underlying assumption of the CAPM? A. Investors consider the first two moments of return distributions B. Investors have random but normally distributed expectations about different assets C. Markets are without taxes and without transaction costs D. Investors consider only one period Answer: B Explanation: The underlying assumptions of...
Question: Which of the following is NOT an underlying assumption of the CAPM? A. Investors consider the first two moments of return distributions B. Investors have random but normally distributed expectations about different assets C. Markets are without taxes and without transaction costs D. Investors consider only one period Answer: B Explanation: The underlying assumptions of...
Question: Which of the following is NOT an underlying assumption of the CAPM? A. Investors consider the first two moments of return distributions B. Investors have random but normally distributed expectations about different assets C. Markets are without taxes and without transaction costs ...
Question: Which of the following is NOT an underlying assumption of the CAPM? A. Investors consider the first two moments of return distributions B. Investors have random but normally...
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12. ### Question 43: Expected return

Question: If the riskless rate is 5% and the expected return of the market portfolio is 9%, what is the expected return, according to the CAPM, of a security with a beta of 1.25? A. 0.07 B. 0.08 C. 0.09 D. 0.1 Answer: D Explanation: The equity risk premium is 9% - 5% = 4%. Please note this is also called the PRICE of RISK. According to the CAPM, the security's expected return =...
Question: If the riskless rate is 5% and the expected return of the market portfolio is 9%, what is the expected return, according to the CAPM, of a security with a beta of 1.25? A. 0.07 B. 0.08 C. 0.09 D. 0.1 Answer: D Explanation: The equity risk premium is 9% - 5% = 4%. Please note this is also called the PRICE of RISK. According to the CAPM, the security's expected return =...
Question: If the riskless rate is 5% and the expected return of the market portfolio is 9%, what is the expected return, according to the CAPM, of a security with a beta of 1.25? A. 0.07 B. 0.08 C. 0.09 D. 0.1 Answer: D Explanation: The equity risk premium is 9% - 5% = 4%. Please...
Question: If the riskless rate is 5% and the expected return of the market portfolio is 9%, what is the expected return, according to the CAPM, of a security with a beta of 1.25? A. 0.07 B....
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13. ### Question 42: Capital market line

Question: The capital market line (CML) includes a portfolio consisting of: I. Only the riskfree asset (100% riskfree), II. All portfolios on the Markowitz Efficient Frontier, III. One portfolio only on the Markowitz Efficient Frontier, IV. Many portfolios with some allocation (100%) of the riskfree asset A. I, II, III B. I, II, IV C. II, III, and IV D. I, III, and IV Answer: D ...
Question: The capital market line (CML) includes a portfolio consisting of: I. Only the riskfree asset (100% riskfree), II. All portfolios on the Markowitz Efficient Frontier, III. One portfolio only on the Markowitz Efficient Frontier, IV. Many portfolios with some allocation (100%) of the riskfree asset A. I, II, III B. I, II, IV C. II, III, and IV D. I, III, and IV Answer: D ...
Question: The capital market line (CML) includes a portfolio consisting of: I. Only the riskfree asset (100% riskfree), II. All portfolios on the Markowitz Efficient Frontier, III. One portfolio only on the Markowitz Efficient Frontier, IV. Many portfolios with some allocation (100%) of the...
Question: The capital market line (CML) includes a portfolio consisting of: I. Only the riskfree asset (100% riskfree), II. All portfolios on the Markowitz Efficient Frontier, III. One portfolio...
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14. ### Question 41: Standard deviation

Question: Consider a two-asset portfolio. The portfolio is equally weighted (50% in each asset) and the standard deviation of return for both assets is 20%. The returns are uncorrelated. What is the portfolio's standard deviation? A. 0.125 B. 0.141 C. 0.174 D. 0.2 Answer: B Explanation: The portfolio variance is given by ([50%^2][20%^2])+([50%^2][20%^2])+(2)(50%)(50%)(20%)(20%)(0)...
Question: Consider a two-asset portfolio. The portfolio is equally weighted (50% in each asset) and the standard deviation of return for both assets is 20%. The returns are uncorrelated. What is the portfolio's standard deviation? A. 0.125 B. 0.141 C. 0.174 D. 0.2 Answer: B Explanation: The portfolio variance is given by ([50%^2][20%^2])+([50%^2][20%^2])+(2)(50%)(50%)(20%)(20%)(0)...
Question: Consider a two-asset portfolio. The portfolio is equally weighted (50% in each asset) and the standard deviation of return for both assets is 20%. The returns are uncorrelated. What is the portfolio's standard deviation? A. 0.125 B. 0.141 C. 0.174 D. 0.2 Answer: B ...
Question: Consider a two-asset portfolio. The portfolio is equally weighted (50% in each asset) and the standard deviation of return for both assets is 20%. The returns are uncorrelated. What is...
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15. ### Question 40: Leverage

Question: Does Jaffer consider leverage a measure of hedge fund risk? A. Yes because risk is a function leverage B. Yes because leverage magnifies correlations C. No because definitions of leverage vary (e.g., gross vs. net) D. No because leverage gears performance and risk equally Answer: D Explanation: Jaffer says that higher levels of leverage are riskier only WITHIN homogeneous...
Question: Does Jaffer consider leverage a measure of hedge fund risk? A. Yes because risk is a function leverage B. Yes because leverage magnifies correlations C. No because definitions of leverage vary (e.g., gross vs. net) D. No because leverage gears performance and risk equally Answer: D Explanation: Jaffer says that higher levels of leverage are riskier only WITHIN homogeneous...
Question: Does Jaffer consider leverage a measure of hedge fund risk? A. Yes because risk is a function leverage B. Yes because leverage magnifies correlations C. No because definitions of leverage vary (e.g., gross vs. net) D. No because leverage gears performance and risk equally ...
Question: Does Jaffer consider leverage a measure of hedge fund risk? A. Yes because risk is a function leverage B. Yes because leverage magnifies correlations C. No because definitions of...
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16. ### Question 39: Optimal portfolio

Question: A risk decomposition for an international portfolio indicates the following. For the Canadian holding, the (marginal) contribution to (monthly portfolio) risk is 0.5% and the marginal contribution to expected return is 0.8%. For the Swiss position, the (marginal) contribution to risk is 1.5% and the marginal contribution to expected return is 1.8%. The portfolio contains a 4% weight...
Question: A risk decomposition for an international portfolio indicates the following. For the Canadian holding, the (marginal) contribution to (monthly portfolio) risk is 0.5% and the marginal contribution to expected return is 0.8%. For the Swiss position, the (marginal) contribution to risk is 1.5% and the marginal contribution to expected return is 1.8%. The portfolio contains a 4% weight...
Question: A risk decomposition for an international portfolio indicates the following. For the Canadian holding, the (marginal) contribution to (monthly portfolio) risk is 0.5% and the marginal contribution to expected return is 0.8%. For the Swiss position, the (marginal) contribution to risk...
Question: A risk decomposition for an international portfolio indicates the following. For the Canadian holding, the (marginal) contribution to (monthly portfolio) risk is 0.5% and the marginal...
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17. ### Question 38: Portfolio risk

Question: The largest risk contributor in an international portfolio is the Swiss index holding (SMI) which constitutes 25% of the portfolio and has a monthly risk contribution of 2%. If the weight in this index were reduced to 20%, what is change in portfolio risk (i.e., for this given position only)? A. An increase of 1.75% (+1.75%) B. A drop of 0.75% (-1.75%) C. An increase of 0.4%...
Question: The largest risk contributor in an international portfolio is the Swiss index holding (SMI) which constitutes 25% of the portfolio and has a monthly risk contribution of 2%. If the weight in this index were reduced to 20%, what is change in portfolio risk (i.e., for this given position only)? A. An increase of 1.75% (+1.75%) B. A drop of 0.75% (-1.75%) C. An increase of 0.4%...
Question: The largest risk contributor in an international portfolio is the Swiss index holding (SMI) which constitutes 25% of the portfolio and has a monthly risk contribution of 2%. If the weight in this index were reduced to 20%, what is change in portfolio risk (i.e., for this given position...
Question: The largest risk contributor in an international portfolio is the Swiss index holding (SMI) which constitutes 25% of the portfolio and has a monthly risk contribution of 2%. If the...
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18. ### Question 37: Benchmark relative

Question: A portfolio outperforms its benchmark index by 2%. The tracking error is 1.4%. For a 95% confidence interval, what is the BENCHMARK-RELATIVE value at risk (VAR) (in percentage terms, without the assumption of a zero-expected-change in portfolio value)? A. 0.15%AnswerA B. 0.3% C. 0.6% D. 1.4% Answer: B Explanation: For benchmark-relative VAR, the only difference is that,...
Question: A portfolio outperforms its benchmark index by 2%. The tracking error is 1.4%. For a 95% confidence interval, what is the BENCHMARK-RELATIVE value at risk (VAR) (in percentage terms, without the assumption of a zero-expected-change in portfolio value)? A. 0.15%AnswerA B. 0.3% C. 0.6% D. 1.4% Answer: B Explanation: For benchmark-relative VAR, the only difference is that,...
Question: A portfolio outperforms its benchmark index by 2%. The tracking error is 1.4%. For a 95% confidence interval, what is the BENCHMARK-RELATIVE value at risk (VAR) (in percentage terms, without the assumption of a zero-expected-change in portfolio value)? A. 0.15%AnswerA B. 0.3% C....
Question: A portfolio outperforms its benchmark index by 2%. The tracking error is 1.4%. For a 95% confidence interval, what is the BENCHMARK-RELATIVE value at risk (VAR) (in percentage terms,...
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19. ### Question 36: Fixed income portfolio performance

Question: Which of the following is not a model used to analyze and decompose fixed-income portfolio performance? A. Benchmark B. Performance attribution C. Synthetic replication D. Additive decomposition Answer: C Explanation: The three methods reviewed are: 1. Comparison to a benchmark: this approach compares the portfolio's rate of return to the benchmark and evaluates the...
Question: Which of the following is not a model used to analyze and decompose fixed-income portfolio performance? A. Benchmark B. Performance attribution C. Synthetic replication D. Additive decomposition Answer: C Explanation: The three methods reviewed are: 1. Comparison to a benchmark: this approach compares the portfolio's rate of return to the benchmark and evaluates the...
Question: Which of the following is not a model used to analyze and decompose fixed-income portfolio performance? A. Benchmark B. Performance attribution C. Synthetic replication D. Additive decomposition Answer: C Explanation: The three methods reviewed are: 1. Comparison to a...
Question: Which of the following is not a model used to analyze and decompose fixed-income portfolio performance? A. Benchmark B. Performance attribution C. Synthetic replication D. Additive...
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20. ### Question 35: Dynamic interest rate models

Question: In regard to dynamic interest rate models, which is a difference between the Vasicek model and the Cox-Ingersoll-Ross (CIR) model? A. Serial correlation B. Drift C. CIR adds long rate as factor (two factors to Vasicek's one factor) D. Heteroskedasticity Answer: D Explanation: Both are stochastic interest models that model the rate around a mean value. The key difference...
Question: In regard to dynamic interest rate models, which is a difference between the Vasicek model and the Cox-Ingersoll-Ross (CIR) model? A. Serial correlation B. Drift C. CIR adds long rate as factor (two factors to Vasicek's one factor) D. Heteroskedasticity Answer: D Explanation: Both are stochastic interest models that model the rate around a mean value. The key difference...
Question: In regard to dynamic interest rate models, which is a difference between the Vasicek model and the Cox-Ingersoll-Ross (CIR) model? A. Serial correlation B. Drift C. CIR adds long rate as factor (two factors to Vasicek's one factor) D. Heteroskedasticity Answer: D ...
Question: In regard to dynamic interest rate models, which is a difference between the Vasicek model and the Cox-Ingersoll-Ross (CIR) model? A. Serial correlation B. Drift C. CIR adds long...
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