# P2.T8. Investment Management

Practice questions for investment management and risk management

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1. ### Question 62: Implicit factor model

Question: Which is arguably the biggest drawback to an implicit factor model? A. Must first identify factors B. No economic interpretation of factors C. Inferior to principal component analysis D. Unwieldy with large datasets Answer: B Explanation: Under implicit (a.k.a., endogenous) factor model, the factors are extracted from the returns. They do not lend themselves to economic...
Question: Which is arguably the biggest drawback to an implicit factor model? A. Must first identify factors B. No economic interpretation of factors C. Inferior to principal component analysis D. Unwieldy with large datasets Answer: B Explanation: Under implicit (a.k.a., endogenous) factor model, the factors are extracted from the returns. They do not lend themselves to economic...
Question: Which is arguably the biggest drawback to an implicit factor model? A. Must first identify factors B. No economic interpretation of factors C. Inferior to principal component analysis D. Unwieldy with large datasets Answer: B Explanation: Under implicit (a.k.a., endogenous)...
Question: Which is arguably the biggest drawback to an implicit factor model? A. Must first identify factors B. No economic interpretation of factors C. Inferior to principal component...
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2. ### Question 61: Arbitrage and emperical models

Question: What are the differences between the arbitrage (APT) and empirical models? A. Factor definition and residual term B. Ex-post versus Ex-ante method C. Use of a market beta D. Number of factors Answer: A Explanation: The difference between the models, aside from the fact that the empirical model contains a residual term is their interpretation of the factors: The APT model...
Question: What are the differences between the arbitrage (APT) and empirical models? A. Factor definition and residual term B. Ex-post versus Ex-ante method C. Use of a market beta D. Number of factors Answer: A Explanation: The difference between the models, aside from the fact that the empirical model contains a residual term is their interpretation of the factors: The APT model...
Question: What are the differences between the arbitrage (APT) and empirical models? A. Factor definition and residual term B. Ex-post versus Ex-ante method C. Use of a market beta D. Number of factors Answer: A Explanation: The difference between the models, aside from the fact that...
Question: What are the differences between the arbitrage (APT) and empirical models? A. Factor definition and residual term B. Ex-post versus Ex-ante method C. Use of a market beta D. Number...
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3. ### Question 60: Portfolio returns

Question: A manager obtains an average alpha of 2% with a tracking error of 10%. How many years are necessary to observe the portfolio returns, before we can be confident that the manager's results are statistically significant (with 95% confidence, but please round up from 1.96 to 2.0 o the t-statistic)? A. 1 year B. 10 years C. 20 years D. 100 years Answer: D Explanation: The...
Question: A manager obtains an average alpha of 2% with a tracking error of 10%. How many years are necessary to observe the portfolio returns, before we can be confident that the manager's results are statistically significant (with 95% confidence, but please round up from 1.96 to 2.0 o the t-statistic)? A. 1 year B. 10 years C. 20 years D. 100 years Answer: D Explanation: The...
Question: A manager obtains an average alpha of 2% with a tracking error of 10%. How many years are necessary to observe the portfolio returns, before we can be confident that the manager's results are statistically significant (with 95% confidence, but please round up from 1.96 to 2.0 o the...
Question: A manager obtains an average alpha of 2% with a tracking error of 10%. How many years are necessary to observe the portfolio returns, before we can be confident that the manager's...
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4. ### Question 59: Extensions

Question: Extensions to Jensen's alpha include each of the following EXCEPT: A. Total risk replaces beta B. The zero-beta portfolio replaces the riskless rate C. The equity risk premium is adjusted for taxes D. All of the above are extensions to Jensen's Answer: D Explanation: The key is to understand Jensen's as extremely generic. As the reading says, "the principle [of the...
Question: Extensions to Jensen's alpha include each of the following EXCEPT: A. Total risk replaces beta B. The zero-beta portfolio replaces the riskless rate C. The equity risk premium is adjusted for taxes D. All of the above are extensions to Jensen's Answer: D Explanation: The key is to understand Jensen's as extremely generic. As the reading says, "the principle [of the...
Question: Extensions to Jensen's alpha include each of the following EXCEPT: A. Total risk replaces beta B. The zero-beta portfolio replaces the riskless rate C. The equity risk premium is adjusted for taxes D. All of the above are extensions to Jensen's Answer: D Explanation: The...
Question: Extensions to Jensen's alpha include each of the following EXCEPT: A. Total risk replaces beta B. The zero-beta portfolio replaces the riskless rate C. The equity risk premium is...
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5. ### Question 58: Performance measures

Question: Which measure is better if we want to evaluate the performance, respectively, of (i) a well-diversified portfolio, (ii) an undiversified portfolio, and (III) a portfolio vis-a-vis PEER PORTFOLIOS with the same beta A. Treynor, Sharpe, Jensen's B. Sharpe, Jensen's, Treynor C. Jensen's, Treynor, Sharpe D. Treynor, Jensen's, Sharpe Answer: A Explanation: The Treynor and the...
Question: Which measure is better if we want to evaluate the performance, respectively, of (i) a well-diversified portfolio, (ii) an undiversified portfolio, and (III) a portfolio vis-a-vis PEER PORTFOLIOS with the same beta A. Treynor, Sharpe, Jensen's B. Sharpe, Jensen's, Treynor C. Jensen's, Treynor, Sharpe D. Treynor, Jensen's, Sharpe Answer: A Explanation: The Treynor and the...
Question: Which measure is better if we want to evaluate the performance, respectively, of (i) a well-diversified portfolio, (ii) an undiversified portfolio, and (III) a portfolio vis-a-vis PEER PORTFOLIOS with the same beta A. Treynor, Sharpe, Jensen's B. Sharpe, Jensen's, Treynor C....
Question: Which measure is better if we want to evaluate the performance, respectively, of (i) a well-diversified portfolio, (ii) an undiversified portfolio, and (III) a portfolio vis-a-vis PEER...
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6. ### Question 57: Portfolios performance

Question: Assume a portfolio has an expected return of 14% with volatility (standard deviation) of 30%; the beta of the portfolio is 1.2. The market's expected return 12% with a volatility of 20%. The riskless rate is 4%. How does the portfolio's performance compare to the market according to the Treynor measure, the Sharpe measure and Jensen's alpha? A. Better (Treynor), better (Sharpe),...
Question: Assume a portfolio has an expected return of 14% with volatility (standard deviation) of 30%; the beta of the portfolio is 1.2. The market's expected return 12% with a volatility of 20%. The riskless rate is 4%. How does the portfolio's performance compare to the market according to the Treynor measure, the Sharpe measure and Jensen's alpha? A. Better (Treynor), better (Sharpe),...
Question: Assume a portfolio has an expected return of 14% with volatility (standard deviation) of 30%; the beta of the portfolio is 1.2. The market's expected return 12% with a volatility of 20%. The riskless rate is 4%. How does the portfolio's performance compare to the market according to...
Question: Assume a portfolio has an expected return of 14% with volatility (standard deviation) of 30%; the beta of the portfolio is 1.2. The market's expected return 12% with a volatility of 20%....
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7. ### Question 56: Performance metric

Question: If managers' bonuses are tied to a performance metric, which performance metric of the following is mostly likely to exacerbate (i.e., make worse) the problem of information asymmetries? (According to Stulz) A. Bonuses linked to EPS growth B. Bonuses linked to EVA C. Bonuses linked to net cash flow D. Bonuses linked to revenue growth Answer: D Explanation: Information...
Question: If managers' bonuses are tied to a performance metric, which performance metric of the following is mostly likely to exacerbate (i.e., make worse) the problem of information asymmetries? (According to Stulz) A. Bonuses linked to EPS growth B. Bonuses linked to EVA C. Bonuses linked to net cash flow D. Bonuses linked to revenue growth Answer: D Explanation: Information...
Question: If managers' bonuses are tied to a performance metric, which performance metric of the following is mostly likely to exacerbate (i.e., make worse) the problem of information asymmetries? (According to Stulz) A. Bonuses linked to EPS growth B. Bonuses linked to EVA C. Bonuses...
Question: If managers' bonuses are tied to a performance metric, which performance metric of the following is mostly likely to exacerbate (i.e., make worse) the problem of information asymmetries?...
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8. ### Question 55: Constituents

Question: Debt overhang implies that a firm may pass on investment opportunities in spite of the fact the investment opportunities might increase firm value. This is due to the fact that which constituents are likely to be worse off? A. New shareholders (that fund the new investment) B. Existing shareholders C. Existing creditors D. All of the above Answer: B Explanation: The...
Question: Debt overhang implies that a firm may pass on investment opportunities in spite of the fact the investment opportunities might increase firm value. This is due to the fact that which constituents are likely to be worse off? A. New shareholders (that fund the new investment) B. Existing shareholders C. Existing creditors D. All of the above Answer: B Explanation: The...
Question: Debt overhang implies that a firm may pass on investment opportunities in spite of the fact the investment opportunities might increase firm value. This is due to the fact that which constituents are likely to be worse off? A. New shareholders (that fund the new investment) B....
Question: Debt overhang implies that a firm may pass on investment opportunities in spite of the fact the investment opportunities might increase firm value. This is due to the fact that which...
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9. ### 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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10. ### 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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11. ### 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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12. ### 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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13. ### 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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14. ### 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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15. ### 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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16. ### 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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17. ### 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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18. ### 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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19. ### 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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20. ### 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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