FINRA Series 7 — All Questions

A customer owns a GNMA pass-through with an original face of $50,000 and a current factor of 0.8000. The pass-through rate is 6%. What interest does the customer receive for one month, ignoring the principal portion?

• a.$2,400
• b.$3,000
• c.$250
• d.$200✓

The current principal is $50,000 x 0.8000 = $40,000. Monthly interest is $40,000 x 6% / 12 = $200. $250 applies the rate to the original $50,000. $2,400 is a full year of interest on the current balance, and $3,000 is a year of interest on the original balance.Ginnie Mae MBS Guide (pass-through factor)

Mortgage rates fall by 1.5 percentage points. Which risk is most immediate for a holder of a GNMA pass-through with a 7% coupon?

• a.Extension risk, because slower prepayments stretch out the average life of the pool
• b.Prepayment risk, as refinancing returns principal early to be reinvested at lower rates✓
• c.Credit risk, because homeowners default and the holder absorbs the losses
• d.Call risk, because Ginnie Mae may call the certificates at par at any time

When mortgage rates fall, homeowners refinance and prepayments speed up, returning principal early to be reinvested at lower yields. Extension risk is what occurs when rates rise and prepayments slow. A GNMA certificate carries a full faith and credit guarantee, which covers timely payment, and Ginnie Mae has no right to call the certificates.Mortgage pass-through risks

A savings bank wants advances to fund its mortgage lending. Which government-sponsored enterprise borrows in the debt market to make such loans to its member institutions?

• a.The Student Loan Marketing Association
• b.The Federal Home Loan Bank System✓
• c.The Federal Home Loan Mortgage Corporation
• d.The Government National Mortgage Association

The Federal Home Loan Banks raise money by issuing debt, then lend it to members (banks, thrifts, insurers) as advances, secured by mortgages and other collateral. Ginnie Mae guarantees securities backed by government-insured loans and does not lend to institutions. Sallie Mae no longer operates as a GSE, and Freddie Mac mainly buys and securitizes mortgages.Federal Home Loan Bank System

A customer receives a $1,400 monthly payment on a GNMA certificate, of which $1,100 is principal and $300 is interest. What part of the payment is taxable income?

• a.All $1,400
• b.Only the $300 interest✓
• c.Only the $1,100 principal
• d.None of it, because a GNMA is guaranteed by the government

Each payment combines interest, which is taxable, with a return of principal, which is not income because it returns the investor's capital. Taxing the whole payment ignores that, and taxing the principal part reverses it. The full faith and credit guarantee covers payment of the amounts due but does not make the interest tax-free.IRS Publication 550 (mortgage-backed securities)

A customer wants an agency mortgage security whose timely payment of principal and interest carries the full faith and credit of the U.S. government. Which should the representative recommend?

• a.A Ginnie Mae pass-through certificate✓
• b.A Freddie Mac participation certificate
• c.A Fannie Mae mortgage-backed security
• d.A Federal Home Loan Bank consolidated bond

Ginnie Mae, a part of HUD, guarantees pass-throughs backed by FHA, VA and certain other federally insured or guaranteed loans, and the guarantee is backed by the full faith and credit of the United States. Fannie Mae and Freddie Mac are GSEs, and the Federal Home Loan Banks are also GSEs whose obligations lack an explicit government guarantee.Agency securities (GSE vs federal agency)

An investor wants a CMO tranche whose average life stays stable as long as prepayment speeds remain within a stated range. Which tranche is designed for that?

• a.A principal-only strip of the pool
• b.A support (companion) tranche
• c.A PAC tranche✓
• d.A Z (accrual) tranche that accrues interest

A PAC follows a schedule of principal payments that is protected within a band of prepayment speeds, because the support tranches absorb the excess or shortfall. The support tranche takes the variability, so its average life swings the most. A Z tranche accrues interest and receives no cash until earlier tranches retire, and a principal-only strip is highly sensitive to prepayments.CMO tranche structures (PAC and support)

Mortgage rates fall sharply, and prepayments on a pool accelerate. What is the effect on the interest-only (IO) and principal-only (PO) strips of a CMO?

• a.Both fall, because faster prepayments reduce the pool
• b.The PO rises in value, and the IO falls in value✓
• c.The IO rises in value, and the PO falls in value
• d.Both rise, because falling rates raise all bond prices

A PO is bought at a discount and returns its full principal sooner when prepayments speed up, so its yield and value rise. An IO is paid only interest on a balance that is being paid down, so faster prepayments cut its cash flows and its value. The reverse holds when rates rise. Both moving the same way misses this opposite sensitivity.CMO strips (IO and PO)

How does the holder of an accrual (Z) tranche in a sequential CMO receive interest in the early years?

• a.Interest accrues into principal, with cash paid only after the earlier tranches retire✓
• b.Interest is paid in a lump sum only at the CMO's final stated maturity date
• c.Interest is paid monthly in cash from the start, as it is for the first tranche
• d.Interest is paid semiannually in cash, and the principal balance stays level

A Z tranche is like a zero-coupon bond until earlier tranches are paid off: its interest is accrued and added to its principal balance rather than paid, after which it receives cash interest and principal. It is not paid monthly in early years, and it is not deferred until the final maturity of the CMO.CMO tranche structures (Z-tranche)

Under the PSA standard, the 100% benchmark begins at 0.2% CPR in month 1 and rises 0.2% per month to 6% in month 30. What is the CPR in month 12 for a pool assumed to prepay at 150% PSA?

• a.4.8%
• b.9.0%
• c.3.6%✓
• d.2.4%

At 100% PSA, month 12 is 12 x 0.2% = 2.4%. At 150% PSA it is 1.5 x 2.4% = 3.6%. 2.4% is the 100% figure, and 4.8% is the 200% PSA figure. 9.0% applies 150% to the 6% ceiling, which is reached only after month 30.PSA prepayment benchmark

A CDO has a $100 million collateral pool. The structure is a $70 million senior tranche, a $20 million mezzanine tranche and a $10 million equity tranche. The pool suffers $15 million of credit losses. Which allocation results?

• a.Equity loses $10 million and mezzanine loses $5 million, while the senior tranche loses nothing✓
• b.Each tranche loses 15% of its balance, or $10.5 million, $3 million and $1.5 million
• c.Senior loses $15 million before the others lose anything
• d.Mezzanine loses $15 million, and equity and senior lose nothing

Losses fall first on the most junior tranche. The $10 million equity tranche is wiped out, the remaining $5 million reduces the mezzanine tranche to $15 million, and the senior tranche is untouched. A pro rata split ignores subordination, and having the senior tranche absorb losses first reverses the order. The mezzanine tranche cannot take all the loss while equity has a balance.CMO and CDO loss waterfall

An ABS trust holds $105 million of auto loans and has issued $100 million of notes. Ignoring excess spread, the loans suffer $7 million of losses. What is the shortfall to the noteholders' principal?

• a.$5 million
• b.$7 million
• c.$2 million✓
• d.$0

The $5 million of overcollateralization absorbs the first losses. The pool falls to $98 million against $100 million of notes, so the noteholders face a $2 million shortfall. $7 million ignores the cushion, $0 ignores that losses exceed it, and $5 million is the size of the cushion, not the remaining loss.Asset-backed securities (overcollateralization)

A sequential CMO has Class A ($30 million), Class B ($40 million) and Class C ($30 million). The pool pays $5 million of principal this month, and Class A still has $18 million outstanding. Who receives the principal?

• a.Class A receives all $5 million✓
• b.The three classes share it pro rata
• c.Class B receives it, since Class A is partly paid
• d.Class C receives it, because it has the longest maturity

In a sequential structure, all principal goes to the first class until it is retired, then to the next. Classes B and C receive interest on their balances in the meantime. Pro rata sharing describes a pass-through, not a sequential CMO, and the later classes receive principal only after Class A is paid off.Sequential-pay CMO

A firm's brochure for a CMO states that its yield is higher than the yield on a bank certificate of deposit and that it is therefore a better choice. How does this fare under FINRA rules?

• a.It violates Rule 2216, which bars CMO communications from comparing them with bank CDs and other investments✓
• b.It is allowed if the brochure shows the current yields of both products side by side in a table
• c.It is allowed if the brochure is approved by a registered principal before use
• d.It violates Rule 2216 only if the brochure is sent to institutional investors

Rule 2216 bars communications about CMOs from comparing them with other investment vehicles, and it names bank certificates of deposit as an example, so giving both yields does not cure it. Principal approval is required for retail communications generally, but it does not make a prohibited comparison acceptable. The restriction is not limited to institutional recipients.FINRA Rule 2216

A dealer borrows $10,000,000 for 7 days in a repo at 4.50%, using an actual/360 basis. What is the interest cost?

• a.$8,750✓
• b.$8,630
• c.$105,000
• d.$450,000

Repo interest is principal x rate x days/360 = $10,000,000 x 0.045 x 7/360 = $8,750. $8,630 uses a 365-day year, which is not the money market convention for repos. $105,000 treats 7 days as 7/30 of a year, and $450,000 is a full year of interest.Repurchase agreement interest (actual/360)

A customer buys a $1,000,000 negotiable CD issued by a bank and holds no other deposits at that bank in the same ownership category. What amount is covered by FDIC insurance if the bank fails?

• a.$250,000✓
• b.$500,000
• c.$100,000
• d.$1,000,000

FDIC insurance covers $250,000 per depositor, per insured bank, per ownership category, and a large negotiable CD is a deposit like any other. The covered amount does not rise with the CD's size. $500,000 and $100,000 are not the limit, and $100,000 was the limit before 2010.FDIC deposit insurance; negotiable certificates of deposit

A U.S. importer buys machinery from a foreign supplier. The importer's bank accepts a time draft payable in 90 days, which the supplier sells at a discount to a money market investor. What is this instrument?

• a.A negotiable certificate of deposit
• b.A Treasury bill
• c.Commercial paper
• d.A banker's acceptance✓

A time draft guaranteed by a bank, used to finance a trade, is a banker's acceptance. It is sold at a discount and paid at face value at maturity, with the bank's credit behind it. Commercial paper is an unsecured note issued by a corporation, a negotiable CD is a deposit certificate, and a Treasury bill is a government obligation.Banker's acceptance

Which type of money market fund may use a stable $1.00 share price under Rule 2a-7?

• a.An institutional tax-exempt fund
• b.A government money market fund✓
• c.An institutional prime fund
• d.A fund that mainly holds commercial paper sold to institutions

Government and retail money market funds may use stable pricing. Institutional prime and institutional tax-exempt funds must have a floating net asset value, so the share price moves with the portfolio, to reduce the incentive for large investors to run. The type of paper held does not by itself allow a stable price.Investment Company Act Rule 2a-7

Under Rule 2a-7, what is the maximum remaining maturity of any single security a money market fund may hold, for most securities?

• a.60 days
• b.120 days
• c.397 calendar days✓
• d.270 days

Rule 2a-7 generally limits each security to a remaining maturity of 397 calendar days, or about 13 months. The 60-day limit applies to the fund's weighted average maturity, and the 120-day limit to its weighted average life. 270 days is the longest maturity of commercial paper exempt from registration, which is not the fund limit.Investment Company Act Rule 2a-7(d)

A 10-year agency note yielded 4.85% when the 10-year Treasury yielded 4.60%. Later, the agency note yields 4.95% and the Treasury yields 4.55%. How did the spread change?

• a.It narrowed by 15 basis points
• b.It was unchanged, because both yields are near 4.9%
• c.It widened by 15 basis points✓
• d.It widened by 10 basis points

The first spread is 4.85% - 4.60% = 25 basis points, and the later one is 4.95% - 4.55% = 40 basis points, so it widened by 15. The agency yield alone rose 10 basis points. A narrowing would mean the gap shrank, and the gap clearly changed.Yield spread arithmetic

A corporate bond yields 120 basis points over the 10-year Treasury, whose yield is 4.20%. Later the Treasury yield falls to 3.90% and the spread widens to 150 basis points. What is the corporate bond's new yield?

• a.5.70%
• b.5.10%
• c.5.85%
• d.5.40%✓

The new yield is the new Treasury yield plus the new spread: 3.90% + 1.50% = 5.40%. 5.10% keeps the old 120-basis-point spread, 5.70% uses the old Treasury yield of 4.20%, and 5.85% treats the spread as a multiplier of the Treasury yield.Credit spread over Treasuries

A company reports sales of $900,000, cost of goods sold of $520,000, operating expenses of $180,000 and interest expense of $60,000. Its tax rate is 25%. What is its net income?

• a.$90,000
• b.$140,000
• c.$35,000
• d.$105,000✓

EBIT is $900,000 - $520,000 - $180,000 = $200,000. Subtracting interest of $60,000 leaves earnings before taxes of $140,000, and tax at 25% is $35,000, so net income is $105,000. The $140,000 figure is the pre-tax amount, with no tax taken out. The $90,000 figure taxes EBIT at 25% ($150,000) and then subtracts interest. The $35,000 figure is the tax bill itself, not the profit left after it.Financial statements: income statement

A company reports net income of $64,000, income taxes of $22,000, interest expense of $11,000, and depreciation and amortization of $18,000. What is its EBITDA?

• a.$97,000
• b.$93,000
• c.$104,000
• d.$115,000✓

Work back up the income statement: $64,000 net income + $22,000 taxes + $11,000 interest + $18,000 depreciation and amortization = $115,000. The $97,000 figure is EBIT, which stops before adding back depreciation and amortization. The $93,000 figure leaves out the tax add-back. The $104,000 figure leaves out the interest add-back.Financial statements: EBITDA

A retailer buys 100 units at $10, later buys 100 units at $12, and then sells 100 units at $20 each. Prices are rising. Using LIFO, what is the gross profit on the sale?

• a.$900
• b.$1,200
• c.$800✓
• d.$1,000

LIFO charges the most recent cost to the units sold, so cost of goods sold is 100 x $12 = $1,200 and gross profit is $2,000 - $1,200 = $800. The $1,000 figure is the FIFO result, which charges the older $10 cost. The $900 figure uses the $11 average cost. The $1,200 figure is LIFO cost of goods sold, not gross profit. In rising prices LIFO reports the lowest profit of the three methods.Financial statements: inventory costing (LIFO vs FIFO)

Equipment costing $100,000 has a five-year life and a salvage value of $10,000. What is the annual depreciation expense under the straight-line method?

• a.$90,000
• b.$100,000
• c.$20,000
• d.$18,000✓

Straight-line depreciation spreads the depreciable base evenly: ($100,000 - $10,000) / 5 years = $18,000 per year. The $20,000 figure divides the full cost by five and ignores salvage value. The $90,000 figure is the depreciable base before it is spread over the five years. The $100,000 figure is the full cost, which is the amount recovered over the whole life and not a single year's expense.Financial statements: depreciation methods

A company pays $50 million to acquire another company whose identifiable net assets have a fair value of $38 million. How does the buyer record the $12 million difference?

• a.As an expense on the income statement in the year of purchase
• b.As a reduction of shareholders' equity at the date of purchase
• c.As a $50 million intangible asset after the purchase is closed
• d.As goodwill, an intangible asset on its balance sheet✓

The amount paid above the fair value of identifiable net assets is capitalized as goodwill and carried as an intangible asset. It is not expensed in the year of purchase and does not reduce shareholders' equity. Only the $12 million excess is goodwill; the $38 million of identifiable net assets is recorded at fair value, so labeling the whole $50 million as an intangible would overstate it.Financial statements: goodwill and intangible assets

An analyst wants to learn which inventory costing method a company uses and the schedule of its long-term debt maturities. Where in the annual report is that detail found?

• a.In the notes (footnotes) to the financial statements✓
• b.In the statement of cash flows, among the financing items
• c.In the income statement, beside the cost of goods sold line
• d.In the auditor's report, within the opinion paragraph itself

The notes to the financial statements disclose accounting policies, such as the inventory method, and details behind balance sheet items, such as debt maturities and contingent liabilities. The income statement reports amounts, not the methods behind them. The cash flow statement shows cash raised or repaid, not the maturity schedule. The auditor's report gives an opinion on the fairness of the statements and does not describe the company's policies.Financial statements: footnotes and auditor's report

A company reports common stock at par of $500,000, paid-in capital in excess of par of $4,500,000, retained earnings of $2,000,000 and treasury stock of $300,000. What is total shareholders' equity?

• a.$6,200,000
• b.$6,700,000✓
• c.$7,300,000
• d.$7,000,000

Equity is par $500,000 + paid-in capital $4,500,000 + retained earnings $2,000,000 = $7,000,000, less treasury stock of $300,000 = $6,700,000. Treasury stock is a contra-equity account because the shares were bought back. The $7,000,000 figure ignores the buyback. The $7,300,000 figure adds the treasury stock instead of subtracting it. The $6,200,000 figure omits the par value.Financial statements: shareholders' equity

During the year a company issued $5 million of bonds, paid $2 million of common dividends, repurchased $1 million of its own stock, and bought $3 million of equipment. What is its net cash from financing activities?

• a.$1 million used
• b.$5 million provided
• c.$2 million provided✓
• d.$3 million provided

Financing activities cover debt, equity and dividends: +$5 million from bonds, -$2 million dividends and -$1 million buyback, for $2 million provided. The equipment purchase is an investing activity and does not belong here; including it would produce $1 million used. The $3 million figure ignores the stock repurchase. The $5 million figure counts only the bond proceeds.Financial statements: cash flow statement

A company begins the year with retained earnings of $1,200,000, earns net income of $400,000, and pays dividends of $150,000. What are its ending retained earnings?

• a.$650,000
• b.$1,750,000
• c.$1,600,000
• d.$1,450,000✓

Ending retained earnings = beginning $1,200,000 + net income $400,000 - dividends $150,000 = $1,450,000. The $1,600,000 figure ignores the dividends paid. The $1,750,000 figure adds the dividends instead of subtracting them. The $650,000 figure subtracts net income instead of adding it.Financial statements: retained earnings

A company reports net income of $200,000, depreciation of $50,000, and an increase in accounts receivable of $30,000. Using the indirect method, what is its cash flow from operating activities?

• a.$250,000
• b.$280,000
• c.$220,000✓
• d.$120,000

Start with net income of $200,000 and add back the non-cash depreciation of $50,000. Receivables that grew by $30,000 mean sales were booked but not yet collected, so that amount is subtracted: $200,000 + $50,000 - $30,000 = $220,000. The $250,000 figure skips the receivables adjustment. The $280,000 figure adds the receivables increase. The $120,000 figure subtracts depreciation as well.Financial statements: cash flow from operations

A company has current assets of $840,000 and current liabilities of $600,000. What is its working capital?

• a.$840,000
• b.$1,440,000
• c.$600,000
• d.$240,000✓

Working capital is current assets minus current liabilities: $840,000 - $600,000 = $240,000. The $1,440,000 figure adds the two instead of subtracting. The $840,000 and $600,000 figures are single inputs, current assets and current liabilities, not the difference between them.Financial ratios: working capital

A company has current assets of $840,000 and current liabilities of $600,000, a current ratio of 1.40. It pays $100,000 of accounts payable with cash. What is its current ratio afterward?

• a.1.48 to 1✓
• b.1.4 to 1
• c.1.2 to 1
• d.1.7 to 1

Paying the payables with cash cuts current assets to $740,000 and current liabilities to $500,000, so the ratio is $740,000 / $500,000 = 1.48. Because the ratio started above 1, using equal amounts of current assets and current liabilities pushes it higher. The 1.4 figure assumes no change. The 1.2 figure (1.23 before rounding) reduces only current assets. The 1.7 figure (1.68 before rounding) reduces only current liabilities.Financial ratios: current ratio

A company has cost of goods sold of $1,200,000, sales of $1,800,000, beginning inventory of $180,000 and ending inventory of $220,000. What is its inventory turnover?

• a.9 times
• b.5.5 times
• c.6.7 times
• d.6 times✓

Inventory turnover is cost of goods sold divided by average inventory. Average inventory is ($180,000 + $220,000) / 2 = $200,000, so $1,200,000 / $200,000 = 6. The 5.5 figure uses only ending inventory. The 6.7 figure uses only beginning inventory. The 9.0 figure uses sales instead of cost of goods sold.Financial ratios: inventory turnover

A company has total assets of $5.0 million and total liabilities of $3.0 million. What is its debt-to-equity ratio, measured as total liabilities divided by shareholders' equity?

• a.0.67 to 1
• b.1.5 to 1✓
• c.0.6 to 1
• d.2.5 to 1

Equity is $5.0 million - $3.0 million = $2.0 million, so $3.0 million / $2.0 million = 1.5 to 1. The 0.6 figure divides liabilities by total assets, which is the debt ratio. The 0.67 figure flips the ratio and divides equity by liabilities. The 2.5 figure divides total assets by equity.Financial ratios: leverage (debt-to-equity)

A company reports earnings before interest and taxes (EBIT) of $3.6 million, depreciation of $1.2 million and annual bond interest of $1.2 million. What is its bond interest coverage ratio?

• a.2.0 times
• b.3.0 times✓
• c.0.33 times
• d.4.0 times

Bond interest coverage is EBIT divided by bond interest: $3.6 million / $1.2 million = 3.0 times. The 4.0 figure uses EBITDA of $4.8 million, which adds back depreciation. The 2.0 figure divides the amount left after interest by interest. The 0.33 figure turns the ratio upside down.Financial ratios: bond interest coverage

A company reports net income of $450,000 and preferred dividends of $50,000. Total shareholders' equity is $3,000,000, of which $500,000 is preferred stock. What is its return on common equity?

• a.13.3%
• b.15%
• c.18%
• d.16%✓

Return on common equity uses earnings available to common and the common equity only: ($450,000 - $50,000) / ($3,000,000 - $500,000) = $400,000 / $2,500,000 = 16%. The 15% figure ignores the preferred altogether. The 13.3% figure removes the dividends but keeps preferred in the equity base. The 18% figure keeps the dividends in earnings but removes preferred from the base.Financial ratios: return on equity

A company has sales of $2,400,000, cost of goods sold of $1,500,000, operating expenses of $500,000 and taxes of $100,000, with no interest expense. What is its net profit margin?

• a.37.5%
• b.16.7%
• c.4.2%
• d.12.5%✓

Net income is $2,400,000 - $1,500,000 - $500,000 - $100,000 = $300,000, and $300,000 / $2,400,000 = 12.5%. The 37.5% figure is the gross margin, measured before operating expenses. The 16.7% figure is the operating margin, measured before taxes. The 4.2% figure is the tax bill as a share of sales.Financial ratios: net profit margin

A company earns $3.00 per share, pays $0.75 per share in dividends and trades at $50. What is its dividend payout ratio?

• a.6%
• b.1.5%
• c.25%✓
• d.75%

The payout ratio is dividends per share divided by earnings per share: $0.75 / $3.00 = 25%. The 1.5% figure is the dividend yield, dividends over price. The 6% figure is the earnings yield, earnings over price. The 75% figure is the share of earnings retained, which is the complement of the payout.Financial ratios: dividend payout ratio

A company has net income of $3,000,000 and 1,000,000 common shares outstanding. It also has convertible bonds that would add 200,000 shares and carry after-tax interest of $300,000. What are its fully diluted earnings per share?

• a.$2.50
• b.$3.00
• c.$2.92
• d.$2.75✓

Assume conversion: add the 200,000 shares to the count and add back the after-tax interest saved. Diluted EPS = ($3,000,000 + $300,000) / 1,200,000 = $2.75. The $3.00 figure is basic EPS before any conversion. The $2.50 figure adds the shares but forgets to add back the interest. The $2.92 figure adds back $500,000 of pre-tax interest instead of the after-tax amount.Financial ratios: fully diluted earnings per share

A company has net income of $5,000,000, 100,000 preferred shares with a $50 par value paying 6%, and 2,000,000 common shares outstanding. What are its earnings per common share?

• a.$2.65
• b.$2.50
• c.$2.24
• d.$2.35✓

Preferred dividends come out first: 100,000 x $50 x 6% = $300,000. Earnings available to common are $4,700,000, and $4,700,000 / 2,000,000 = $2.35. The $2.50 figure ignores the preferred dividend. The $2.65 figure adds the dividend instead of subtracting it. The $2.24 figure divides by 2,100,000 shares, counting the preferred shares in the common share count.Financial ratios: earnings per share after preferred dividends

A company has total assets of $90 million, intangible assets of $10 million and current liabilities of $20 million. It has 40,000 bonds of $1,000 par outstanding and no other debt. What is the asset coverage per bond?

• a.$1,500✓
• b.$2,250
• c.$1,750
• d.$2,000

Net tangible assets are total assets less intangibles and current liabilities: $90 million - $10 million - $20 million = $60 million. Divided by 40,000 bonds, coverage is $1,500 per bond. The $2,250 figure uses total assets without any deduction. The $2,000 figure ignores current liabilities. The $1,750 figure ignores intangibles.Financial ratios: asset coverage per bond

A company reports net income of $7,200,000, depreciation of $2,400,000, and 3,000,000 shares outstanding. What is its cash flow per share, measured as net income plus depreciation divided by shares?

• a.$1.60
• b.$2.40
• c.$3.20✓
• d.$0.80

Cash flow adds back the non-cash depreciation charge: ($7,200,000 + $2,400,000) / 3,000,000 = $3.20. The $2.40 figure is earnings per share, with no add-back. The $1.60 figure subtracts depreciation instead of adding it. The $0.80 figure is depreciation per share alone.Financial ratios: cash flow per share

A stock has a beta of 1.5. The risk-free rate is 3% and the expected return on the market is 9%. What return does the capital asset pricing model require for this stock?

• a.12%✓
• b.13.5%
• c.9%
• d.16.5%

CAPM required return = risk-free rate + beta x (market return - risk-free rate) = 3% + 1.5 x (9% - 3%) = 12%. The 9% figure is simply the market return, which fits a beta of 1.0. The 13.5% figure multiplies beta by the whole market return and ignores the risk-free rate. The 16.5% figure adds the risk-free rate to beta times the whole market return instead of the 6% premium.Portfolio theory: capital asset pricing model

A stock with a beta of 1.2 returned 11% over the year. The risk-free rate was 2% and the market returned 8%. What was the stock's alpha?

• a.9.2%
• b.+3%
• c.-1.8%
• d.+1.8%✓

Expected return under CAPM = 2% + 1.2 x (8% - 2%) = 9.2%. Alpha is the actual return minus the expected return: 11% - 9.2% = +1.8%, so the stock beat what its risk called for. The -1.8% figure reverses the subtraction. The +3% figure compares the stock with the market return of 8% and ignores beta. The 9.2% figure is the expected return itself, not the excess over it.Portfolio theory: alpha

A portfolio has an expected annual return of 8% and a standard deviation of 12%. If returns are normally distributed, within what range will the return fall about 68% of the time?

• a.-4% to 8%
• b.-4% to 20%✓
• c.-16% to 32%
• d.8% to 20%

About 68% of outcomes fall within one standard deviation of the mean: 8% - 12% = -4% and 8% + 12% = 20%. The range of -16% to 32% is two standard deviations, which covers about 95% of outcomes. The ranges of -4% to 8% and 8% to 20% each look only one side of the mean, so neither describes the symmetric band.Portfolio theory: standard deviation

The risk-free rate is 3%. Portfolio A earned 12% with a standard deviation of 15%. Portfolio B earned 9% with a standard deviation of 8%. Which portfolio performed better on a risk-adjusted basis by the Sharpe ratio?

• a.Portfolio A, because its 12% return is higher than Portfolio B's 9% return
• b.Portfolio A, since its 9-point excess return beats B's 6 points
• c.Neither, since both portfolios beat the risk-free rate by a wide margin
• d.Portfolio B, at 0.75 of excess return per unit of risk, against A's 0.60✓

The Sharpe ratio is (return - risk-free rate) / standard deviation. Portfolio A: (12% - 3%) / 15% = 0.60. Portfolio B: (9% - 3%) / 8% = 0.75. Portfolio B earned more excess return for each unit of risk. Looking only at raw return or raw excess return ignores risk, which is what the ratio adjusts for. Both beating the risk-free rate says nothing about how efficiently each did it.Portfolio theory: Sharpe ratio

A customer holds 40 stocks spread across many industries. Which risk is NOT meaningfully reduced by adding more stocks of this kind?

• a.Business risk specific to one company's operations
• b.Management risk tied to one firm's executive team
• c.Event risk from a lawsuit against a single issuer
• d.Market risk that moves nearly all stocks together✓

Diversification removes unsystematic risk, the risk peculiar to one issuer, such as its operations, a lawsuit or its management. Systematic (market) risk affects virtually all stocks at once, so holding more of them leaves it largely intact. Only hedging, asset allocation to other asset classes or a lower beta changes exposure to it.Portfolio theory: systematic and unsystematic risk

An advisor wants to lower the volatility of a customer's all-stock portfolio by adding one more holding. Which candidate offers the greatest diversification benefit?

• a.A small-cap fund with a correlation of +0.6 to it
• b.An asset with a correlation of 0 to the portfolio
• c.A second large-cap fund with a correlation of +0.9
• d.An asset with a correlation of -0.8 to the portfolio✓

The lower the correlation, the more the new holding's swings offset those of the portfolio, so -0.8 gives the largest reduction in volatility. A correlation near +1 adds almost nothing, and +0.6 helps only a little. Zero correlation helps, but offsetting movement from a negative correlation is stronger.Portfolio theory: correlation and diversification

A customer who works for a public company has 70% of her portfolio in her employer's stock and says she wants to keep it because she knows the business well. Which recommendation best fits her suitability profile?

• a.Sell the position in stages and diversify into a broader mix✓
• b.Buy shares of the employer's top competitors to spread out the holding
• c.Keep the position, since her knowledge of the company lowers the risk
• d.Buy more through payroll deductions, building on her knowledge

A 70% position in one issuer exposes both her portfolio and her paycheck to the same company. Reducing it gradually and diversifying the proceeds addresses concentration risk while allowing for taxes and timing. Familiarity does not remove company-specific risk. Competitors in the same industry share many of the same risks, so they diversify little, and adding to the position makes the concentration worse.Portfolio construction: concentrated positions

A portfolio manager's policy target is 60% stocks and 40% bonds. Expecting stocks to outperform over the next six months, she temporarily moves to 70% stocks and 30% bonds. What is this strategy called?

• a.Strategic allocation
• b.Tactical asset allocation✓
• c.Dollar-cost averaging
• d.Constant-mix rebalancing

Tactical asset allocation makes short-term deviations from the long-term target to exploit expected market conditions. Strategic asset allocation is the long-term 60/40 mix itself. Rebalancing would move the portfolio back toward the target, not away from it. Dollar-cost averaging means investing a fixed dollar amount at regular intervals.Portfolio construction: tactical asset allocation