Sample Qualitative Analysis Exam

 

Short Essay.

Question 1. Discuss, in detail, the agency problem. (Short Essay, 5 points)

Ans: Managers are the agents of the shareholders, and should act on their behalf to maximize shareholder wealth (the value of the stock). A conflict (the agency conflict) arises when managers take self-interested actions to the detriment of shareholders. The roles of the board of directors selected by the shareholders are to oversee management and to minimize agency problems. However, often these boards are figureheads, and individual shareholders do not own large enough blocks of the shares to override management actions. One potential resolution of an agency problem occurs when inefficient management actions cause the price of the stock to be depressed. The firm may then become a takeover target. If the acquisition is successful, managers may be replaced and potentially, stockholders benefit.

Question 2. Of the secondary stock markets, which have been expanding and which have been contracting? Give some of the reasons for the changes. (Short essay, 7 points)

Ans: The over the counter market (OTC) has grown dramatically in recent years. The market has become much more automated and information-efficient. The National Association of Security Dealers Automated Quotations (NASDAQ) system is part of the reason for this growth. NASDAQ consists of the more broadly traded OTC stocks. Up to date price quotations are available on these stocks, and thus investors are much more willing to invest in these stocks than prior to the creation of this system. In recent years, many firms which have grown large enough to qualify for NYSE listing have chosen to remain NASDAQ traded.

The OTC market has taken some growth from the NYSE, largely due to the increased technology of the OTC market. The American Stock Exchange (AMEX) has decreased in size dramatically in recent years. This exchange is being pressured both from the top and from the bottom. That is, as mergers and acquisitions occurred (primarily in the 1980s), often two AMEX firms merged into one firm large enough for NYSE listing. In addition, the AMEX also has experienced the pressure from the OTC market as larger firms chose to remain in that market.

Question 3. Describe how an investor may combine a risk-free asset and one risky asset in order to obtain the optimal portfolio for that investor. (Short essay, 10 points)

Ans: The investor may combine a risk-free asset (U. S. T-bills or a money market mutual fund) and a risky asset, such as an indexed mutual fund in the proper portions to obtain the desired risk-return relationship for that investor. The investor must realize that the risk-return relationship is a linear one, and that in order to earn a higher return, the investor must be willing to assume more risk. The investor must first determine the amount of risk that he or she can tolerate (in terms of the standard deviation of the total portfolio, which is the product of the proportion of total assets invested in the risky asset and the standard deviation of the risky asset). One minus this weight is the proportion of total assets to be invested in the risk-free asset. The portfolio return is the weighted averages of the returns on the two respective assets. Such an asset allocation plan is probably the easiest, most efficient, and least expensive for the individual investor to build an optimal portfolio.

Question 4. Discuss the tax status of the major categories of institutional investors described in the text. (Short essay, 10 points)

Ans: Mutual funds, pension plans, and endowment funds are not subject to taxation on the earnings of the portfolios. The other institutional investors are subject to income tax. Mutual funds are not taxed if certain requirements regarding diversification and the passing of earnings on to investors are met. Mutual funds do not own the funds they are investing; the shareholders own the funds, the mutual funds are merely performing the investment service. Investors pay taxes on what they earn from the funds. Pension plans do not pay income tax; the benefits are taxed when received. Endowments are portfolios of not-for-profit entities, and thus are tax-free.

Long Essay: 28 points

Question 5. List and describe seven of the more important types of mutual funds according to their investment policy and use. (Essay 28 points)

Ans: Some of the more important fund types, classified by investment policy, are:

Money Market Funds - These funds invest in money market securities. They usually offer check-writing features and NAV is fixed at $1 per share, so that there are no tax implications associated with redemption of shares. They provide low risk, relatively low return and high liquidity.

Equity Funds - These funds invest primarily in stock, although they may hold other types of securities at the manager's discretion. They may also hold some money market securities to provide liquidity for share redemption. Typical objectives are capital gain, growth, growth and income, income, and income and security.

Fixed-Income Funds - These funds specialize in fixed-income securities such as corporate bonds, Treasury bonds, mortgage-backed securities or municipal bonds. These funds may specialize by maturity or credit risk as well.

Balanced and Income Funds - These funds may substitute for an investor's entire portfolio. They hold a mix of fixed-income and equity securities. Income funds try to maintain safety of principal but achieve liberal current income, while balanced funds seek to minimize risk.

Asset Allocation Funds - These funds also hold both stocks and bonds, but vary the proportions in accord with the portfolio manager's forecast of the relative performance of each sector. These funds are engaged in market timing and are therefore higher risk.

Index Funds - These funds try to match the performance of a broad market index. They buy shares in securities included in a particular index in proportion to the security's representation in that index. Index funds are a low-cost way for small investors to pursue a passive investment strategy.

Specialized Sector Funds - These funds concentrate on a particular industry or industries. Held alone, they are not well-diversified and may be higher risk.

Multiple Choice : 1 point each.

Question 6. For the period 1926 to 1996, __________ had the highest arithmetic average returns of the alternatives available.

A) common stocks of small firms

B) common stocks of large firms

C) long-term Treasury bonds

D) U. S. Treasury bills

E) none of the above

Ans: A

Question 7. The comparison universe is __________.

A) a concept found only in astronomy

B) the set of all mutual funds in the world

C) the set of all mutual funds in the U. S.

D) a set of mutual funds with similar risk characteristics to your mutual fund

E) none of the above

Ans: D

Question 8. The money management industry uses dollar-weighted returns __________ for performance evaluation.

A) more frequently than time-weighted returns

B) as frequently as time-weighted returns

C) less frequently than time-weighted returns

D) all the time

E) none of the time

Ans: C

Question 9. Suppose you purchase one share of the stock of Volatile Engineering Corporation at the beginning of year 1 for $36. At the end of year 1, you receive a $2 dividend, and buy one more share for $30. At the end of year 2, you receive total dividends of $4 (i.e., $2 for each share), and sell the shares for $36.45 each. The time-weighted return on your investment is __________.

A) -1.75%

B) 4.08%

C) 8.53%

D) 11.46%

E) 12.35%

Ans: C

Question 10. Historically, the average arithmetic return of Parametric Design Company has been 12%. If the returns have been normally distributed with a variance of 6%, the geometric average return on this stock has been __________.

A) 4%

B) 8%

C) 12%

D) 9%

E) none of the above

Ans: D

Question 11. A portfolio of corporate bonds is best hedged with:

A) Futures contracts written on corporate bonds.

B) Futures contracts written on U. S. government bonds

C) Futures contracts written on U. S. Treasury bills.

D) Futures contracts written on the S&P 500.

E) None of the above.

Ans: B

Question 12. The ____________ refers to the potential conflict between management and shareholders due to management's control of pecuniary rewards as well as the possibility for incompetent performance by managers.

A) agency problem

B) diversification problem

C) liquidity problem

D) solvency problem

E) regulatory problem

Ans: A

Question 13. In the event of the firm's bankruptcy

A) the most shareholders can lose is their original investment in the firm's stock.

B) common shareholders are the first in line to receive their claims on the firm's assets.

C) bondholders have claim to what is left from the liquidation of the firm's assets after paying the shareholders.

D) the claims of preferred shareholders are honored before those of the common shareholders.

E) a and d.

Ans: E

Question 14. Which of the following indices is (are) market-value weighted?

I) The New York Stock Exchange Composite Index.Response

II) The Standard and Poor's Composite 500 - Stock Index.Response

III) The Dow Jones Industrial Average.

A) I only

B) I and II only

C) III only

D) I, II, and III only

E) I, II, III, and IV

Ans: B

Question 15. Management fees and other expenses of mutual funds may include

A) front-end loads.

B) back-end loads.

C) 12b-1 charges.

D) a and b only.

E) a, b and c.

Ans: E

Question 16. Which of the following functions do mutual fund companies perform for their investors?

A) Record keeping and administration

B) Diversification and divisibility

C) Professional management

D) Lower transaction costs

E) All of the above.

Ans: E

Question 17. __________ refer to strategies aimed at attaining the established rate of return requirements while meeting expressed risk tolerance and applicable constraints.

A) Investment constraints

B) Investment objectives

C) Investment policies

D) All of the above

E) None of the above

Ans: C

Question 18. The over-the-counter market

A) has been growing in recent years.

B) is a very automated market.

C) contains some firms that qualify for NYSE listing.

D) a and b.

E) a, b, and c.

Ans: E

Question 19. Initial margin requirements are determined by

A) the Securities and Exchange Commission.

B) the Federal Reserve System.

C) the New York Stock Exchange.

D) b and c.

E) a and b.

Ans: B

Question 20. Assume you sold short 100 shares of common stock at $50 per share. The initial margin is 60%. What would the maintenance margin be if a margin call is made at a stock price of $60?

A) 40%

B) 33%

C) 35%

D) 25%

E) none of the above

Ans: B

$5,000 X 1.6 = $8,000

[$8,000 - 100(60) 100(60) = 33%

BA / Fin-Ec 261 Second Midterm

Long Answer (20 points)

1. Discuss the various forms of market efficiency. Include in your discussion the information sets involved in each form and the relationships across information sets and across forms of market efficiency. Also discuss the implications for the various forms of market efficiency for the various types of securities' analysts.

Ans: The weak form of the efficient markets hypothesis (EMH) states that stock prices immediately reflect market data. Market data refers to stock prices and trading volume. Technicians attempt to predict future stock prices based on historic stock price movements. Thus, if the weak form of the EMH holds, the work of the technician is of no value.

The semistrong form of the EMH states that stock prices include all public information. This public information includes market data and all other publicly available information, such as financial statements, and all information reported in the press relevant to the firm. Thus, market information is a subset of all public information. As a result, if the semistrong form of the EMH holds, the weak form must hold also. If the semistrong form holds, then the fundamentalist, who attempts to identify undervalued securities by analyzing public information is unlikely to do so consistently over time. In fact, the work of the fundamentalist may make the markets even more efficient!

The strong form of the EMH states that all information (public and private) is immediately reflected in stock prices. Public information is a subset of all information, thus if the strong form of the EMH holds, the semi-strong form must hold also. The strong form of EMH states that even with inside (legal or illegal) information, one cannot expect to outperform the market consistently over time.

Studies have shown the weak form to hold, when transactions costs are considered. Studies have shown the semi-strong form to hold in general, although some anomalies have been observed. Studies have shown that some insiders (specialists, major shareholders, major corporate officers) do outperform the market.

Short Answer (10 points each)

2. The price/earnings ratio, or multiplier approach, may be used for stock valuation. Explain this process and describe how the "multiplier" varies from the one available in the stock market quotation pages and illustrate the formula.

Ans: The price earnings ratio used for stock valuation should be the predicted price/earnings ratio. That is, the ratio of the current price of the stock divided by the expected earnings per share for the coming year. Thus, the ratio is the stock price as a percentage of expected earnings. All valuation models should be based on what the investor is expecting to receive in the coming period, not upon what past investors have received. Such a forecasted price/earnings ratio is published in Value Line. The analyst/investor can simplistically multiply the value of that published ratio by the forecasted earnings per share (also published by Value Line), the forecasted earnings per share numbers cancel out; the result being the intrinsic value of the stock described as:

PO/e1 X e1 = PO.

3. Discuss the tools of the U. S. government's "demand-side" policy. Include in your discussion of these tools the relative advantages and disadvantages of each in terms of the effect of the use of these tools on the economy.

Ans: The two tools of the government's "demand-side" policy are fiscal and monetary policy. Fiscal policy is the use of government spending and taxing for the specific purpose of stabilizing the economy. Fiscal policy, once enacted, has the most direct and immediate effect on the economy. However, the formulation and implementation of fiscal policy is extremely slow, as such policy must be approved by both the legislative and executive branches of the federal government. Monetary policy consists of actions taken by the Board of Governors of the Federal Reserve System (FRS) to influence the money supply and/or interest rates. Monetary policy is relatively easy to formulate and to implement, but has less direct impact on the economy than fiscal policy. The most widely used tool of the FRS is the open market operations, in which the Fed buys or sells bonds for the Fed's account. Buying securities increases the money supply; selling securities decreases the money supply. Open market operations occur daily. Other FRS tools include adjusting the discount rate, which is the interest rate the Fed charges banks on short-term loans, and altering reserve requirements, which are the fraction of deposits that banks must maintain in cash deposits with the Fed. Reductions in the money supply signal an expansionary monetary policy; lowering reserve requirements increase the money supply, and thus, stimulate the economy. The Fed walks a fine line: expansionary monetary policy probably will lower interest rates and stimulate investment and consumption in the short run, but ultimately inflation probably will result.

4. Discuss the mutual fund theorem.

Ans: The mutual fund theorem is based on the concept that investors may obtain an efficient portfolio by holding the market (investing in an S&P 500 index fund, for example). The investor may adjust his or her holdings to the appropriate risk level by combining this investment with investment in risk-free instruments. Thus, the investor is separating the investment decision from the financing decision (separation theorem). Using this approach the investor may have an efficient passive investment strategy.

5. Discuss the "adjusted betas" published by Merrill Lynch in Security Risk Evaluation. Include an example of an adjusted beta in your answer.

Ans: Over time, security betas move toward 1, as the average beta of all securities is 1 and variables regress toward the mean. Thus, if a historic beta has been greater than 1, the chances are that in the future, this beta will be less than the historic beta. The opposite relationship will be observed if the historic beta has been less than one. Merrill Lynch uses the following relationship to calculate "adjusted betas".

Adjusted beta = 2/3 (sample beta) 1/3 (1).

Multiple choice (1 point each)

6. In the context of the Capital Asset Pricing Model (CAPM) the relevant measure of risk is

A) unique risk.

B) beta.

C) standard deviation of returns.

D) variance of returns.

E) none of the above.

Ans: B

7. In a well diversified portfolio

A) market risk is negligible.

B) systematic risk is negligible.

C) unsystematic risk is negligible.

D) nondiversifiable risk is negligible.

E) none of the above.

Ans: C

8. Studies of liquidity spreads in security markets have shown that

A) liquid stocks earn higher returns than illiquid stocks.

B) illiquid stocks earn higher returns than liquid stocks.

C) both liquid and illiquid stocks earn the same returns.

D) illiquid stocks are good investments for frequent, short-term traders.

E) None of the above are true.

Ans: B

9. Suppose you held a well-diversified portfolio with a very large number of securities, and that the single index model holds (Chapter 10). If the s of your portfolio was 0.20 and sM was 0.16, the b of the portfolio would be approximately ________.

Ans: 1.25

10. Analysts may use regression analysis to estimate the index model for a stock. When doing so, the slope of the regression line is an estimate of ______________.

A) the alpha of the asset

B) the beta of the asset

C) the sigma of the asset

D) the delta of the asset

5. 1. none of the above

Ans: B

11. Suppose the following equation best describes the evolution of b over time:

bt = 0.25 0.75bt-1. If a stock had a b of 0.6 last year, you would forecast the b to be _______ in the coming year.

A) 0.45

B) 0.60

C) 0.70

D) 0.75

E) none of the above

Ans: C

12. A zero-investment portfolio with a positive expected return arises when _________.

A) an investor has downside risk only

B) the law of prices is not violated

C) the opportunity set is not tangent to the capital allocation line

D) a risk-free arbitrage opportunity exists

E) none of the above

Ans: D

13. The Arbitrage Pricing Theory requires a benchmark portfolio

A) that is equal to the true market portfolio.

B) that contains all securities in proportion to their market values.

C) that need not be well-diversified.

D) that is well-diversified and lies on the SML.

E) that is unobservable.

Ans: D

14. An important difference between Capital Asset Pricing Model and the Arbitrage Pricing Theory is

A) CAPM depends on risk-return dominance; APT depends on a no arbitrage condition.

B) CAPM assumes many small changes are required to bring the market back to equilibrium; APT assumes a few large changes are required to bring the market back to equilibrium.

C) implications for prices derived from CAPM arguments are stronger than prices derived from APT arguments.

D) all of the above are true.

E) both a and b are true.

Ans: E

15. A long term movement of prices, lasting from several months to years is called _________.

A) a minor trend

B) a primary trend

C) an intermediate trend

D) trend analysis

E) b and d

Ans: B

16. A trin ratio of less than 1.0 is considered as a _________.

A) bearish signal

B) bullish signal

C) bearish signal by some technical analysts and a bullish signal by other technical analysts

D) bullish signal by some fundamentalists

E) c and d

Ans: B

17. To improve the likelihood of choosing "winning" mutual fund managers, investors should look for

A) a long and consistent track record by the manager.

B) a fund that is not excessively large.

C) a fund style that is consistent with their own portfolio needs.

D) all of the above.

E) none of the above.

Ans: D

18. Lifecycle Bicycle Company is expected to pay a dividend in year 1 of $1.20, a dividend in year 2 of $1.50, and a dividend in year 3 of $2.00. After year 3, dividends are expected to grow at the rate of 10% per year. An appropriate required return for the stock is 14%. The stock should be worth _______ today.

Ans: $40.67

19. If a firm's required rate of return equals the firm's return on equity, there is no advantage to increasing the firm's growth. Suppose a no-growth firm had a required rate of return and a ROE of 12% and a stock price of $40. However, if the firm is able to increase the ROE to 15% with a plowback ratio of 50%, what is the present value of growth opportunities now? (Last year's dividends were $2.00/share).

A) $9.78

B) $7.78

C) $10.78

D) $12.78

E) none of the above

Ans: B

20. Historically, P/E ratios have tended to be _________.

A) higher when inflation has been high

B) lower when inflation has been high

C) uncorrelated with inflation rates but correlated with other macroeconomic variables

D) uncorrelated with any macroeconomic variables including inflation rates

E) none of the above

Ans: B

21. The _______ is defined as the present value of all cash proceeds to the investor in the stock.

A) dividend payout ratio

B) intrinsic value

C) market capitalization rate

D) plowback ratio

E) none of the above

Ans: B

22. The most widely used monetary tool is ___________.

A) altering the discount rate

B) altering the reserve requirements

C) open market operations

D) altering marginal tax rates

E) none of the above

Ans: C

23. If the economy is going into a recession, an attractive industry to invest in would be the ________ industry.

A) automobile

B) medical services

C) construction

D) a and c

E) b and c

Ans: B

24. The stock price index and contracts and orders for plant and equipment are

A) leading economic indicators.

B) coincidental economic indicators.

C) lagging economic indicators.

D) not useful as economic indicators.

E) none of the above.

Ans: A

25. If a professionally managed portfolio consistently outperforms the market proxy on a risk-adjusted basis and the market is efficient, it should be concluded that ______________.

A) the CAPM is invalid

B) the proxy is inadequate

C) either the CAPM is invalid or the proxy is inadequate

D) the CAPM is valid and the proxy is adequate

E) none of the above

Ans: C

DENNIS P. McNAMEE, J.D.- ALL RIGHTS RESERVED