Deck 8: Investment Products and Markets: an Introduction

Question 1

Define investment derivatives. Also, present examples of some of the key derivatives.

Answer 1

Derivatives are financial instruments that, like futures, are derived from an underlying transaction in goods (stocks, bonds, or money itself). Originally invented for commodities providers as a hedge against price fluctuations, futures and options also give speculators the chance to make a fortune or lose everything.
Examples:
Option Spreads: A call option gives the holder the right to buy the underlying asset on or before a certain date, and at a certain price. A put option gives the holder the right to sell the underlying asset on or before a certain date, and at a certain price. An infinite variety of option spreads exist today. These include yield curve spreads, money-market spreads, spreads on London Inter Bank Offered Rate (LIBOR), T-bills, and Euro-dollar futures, and spreads on mortgage swap, commodities currency, and hybrid equity and bond markets.
Straddles and Strips: These are combination option trading strategies which involve taking a position in both calls and puts on the same stock. Of these, the straddles are the most common strategy. It involves buying equal amounts of puts and calls with the same strike price, the same underlying asset index or currency, and the same expiration date.

Question 2

What are junk bonds? Are they worthless?

Answer 2

In Wall Street terminology, corporate bonds rated below BAA by Moody's or below BBB by Standard & Poor's (S&P's) are characterized as junk bonds, whereas bonds with higher ratings are identified as investment quality bonds. The connotation junk comes from the investment community's belief that, under unfavorable economic conditions, market prices of such bonds will significantly drop, producing at least a paper loss. Most junk bonds are not worthless. As a matter of fact, depending upon the risk tolerance level, junk bonds may very well be an appropriate investment in the portfolios of some investors.

Question 3

Describe index funds. What are the key advantages they enjoy over managed funds?

Answer 3

Traditionally, index funds were used by institutional investors who wanted to diversify and earn returns close to the market return. At first blush, index funds do not appear to be glamorous. They are designed not to do better or worse than the market they reflect. But in the long run, these funds may prove that slow and steady wins the race. Academic studies show that index funds offer better returns than many actively managed funds.
Index funds have two other advantages over managed funds. First, transactions and sales costs of these funds are minimal: The average expense ratio of these funds could be as low as 0.18 percent versus 1.40 percent for managed funds. Second, because there is little turnover, index funds do not generate as much taxable capital gains as most managed mutual funds do.

Question 4

What are fixed-income securities? List the major types of fixed-income securities available today.

Question 5

What are preferred stocks? Are there different types of preferred stocks?

Question 6

Describe the various types of mutual funds classified according to their investment objectives.

Question 7

Explain the nature of Treasury Inflation-Protection Securities or TIPS.

Question 8

Compare and contrast no-load and load funds.

Question 9

Comment on the following statement: "Mutual funds charge so many fees that it is impossible to make any money by investing through them."

Question 10

What are the three popular nonmarketable government issues?

Question 11

Compare and contrast warrants and rights.

Question 12

Explain what is meant by fund alphabet soup.

Question 13

Distinguish between various types of stocks classified according to their investment grades.

Question 14

Compare closed-end companies with mutual funds.

Question 15

Jane Bryant, a widow, bought a AAA-rated, long-term bond issued by Ford because it was safe and guaranteed. However, she is upset because in yesterday's paper it was reported that the price of her bond dropped by 1/4 ($2.50). Can you calm her down?

Question 16

Describe the various types of municipal bonds that represent an integral part of the fixed-income securities market.

Question 17

Comment on the following statement: "A mutual fund prospectus is full of legalese and provides little useful information."

Question 18

Discuss various types of marketable government issues available to investors.

Question 19

Describe the nature of short selling as a part of an investment strategy.

Question 20

Distinguish between various types of corporate bonds. Which is the best type of bond from an investor's point of view?

Question 21

Sylvia Booma has just learned that there are two different ways of investing in the equity market; namely, equity mutual funds and SPVL. She doesn't understand the difference between the two, however. Can you help?

Question 22

Question 12. Holders of common stocks:

A) Have ownership rights
B) Have an equity interest in the corporation and thus are usually the only group to participate in increased earnings of the corporation
C) Do not participate in management elections
D) Retain rights to be paid before general creditors
E) A and B

Question 23

Question 11. Which of the following factors are not taken into consideration by bond rating companies when evaluating a bond?

A) Fixed charge coverage
B) Debt-to equity ratio
C) Liquidity ratio
D) Significance of the company within the industry
E) Bond rating companies take into consideration all of the above features

Question 24

Question 15. If an investor purchases a no-load fund, she or he:

A) Is never subject to a management fee
B) Could be subject to a front-end commission
C) Could be subject to 12b-1 fees
D) Would expect a higher return since no-loads generally pay better rates than load funds
E) C and D

Question 25

Question 9. Zero-coupon bonds:

A) Offer periodic interest payments
B) Are sold at a deep discount from par
C) Gradually increase in value as they approach maturity
D) B and C
E) A and C

Question 26

Question 13. Which of the following company stocks typically do not pay dividends so they can maintain or accelerate their growth by reinvesting the earnings in the company?

A) Blue-chip
B) Income
C) Secular
D) Growth
E) None of the above-companies typically do not do this

Question 27

Question 5. Which of the following are true with respect to federal agency securities?

A) They are fully owned by the US Government
B) They carry a small degree of default risk since their ability to pay is based on the government's power to tax
C) They are comprised of stocks originally owned by the US Treasury
D) A and B
E) B and C

Question 28

Question 3. Which of the following investments are quoted on a discount basis?

A) Treasury bills
B) Certificates of deposit
C) Treasury notes
D) Certificates of indebtedness
E) Corporate bonds

Question 29

Question 4. Which of the following is/are true with respect to Treasury notes and bonds?

A) There are NOT quoted as a percentage of par
B) Price fluctuations are represented by 1/32's of a point
C) Price fluctuations are represented by 1/8's of a point
D) A and B
E) A and C

Question 30

Question 14. Which of the following is not true with respect to mutual funds?

A) They could be open-end or close-end
B) They continually offer new shares
C) Net asset value is calculated by subtracting all liabilities from the market value of all securities held in the portfolio and multiplying this figure by the outstanding shares
D) Shares may be redeemed at net asset value at any time
E) A and C

Question 31

John Dingle is impressed by the cliché, "Buy real estate, because they don't make any more of that stuff." He wants your advice on this type of investment.

Question 32

Question 6. Which of the following bonds are dependent on the income specifically from the issuing entity or project?

A) Municipal
B) General obligation
C) Revenue
D) Corporate
E) A and C

Question 33

Question 1. Which of the following investments are fixed with respect to the rate of return they pay?

A) Treasury bills/bonds
B) Certificates of deposit
C) Savings accounts
D) Municipal bonds
E) All of the above are fixed investments

Question 34

At a recent seminar you stated that the yield on a Xerox corporate bond was 9.2 percent whereas the yield on the Chrysler stock was 3.6 percent. An attendee has concluded from this statement that the Xerox bond is a far better investment than the Chrysler stock. How do you respond to this conclusion?

Question 35

Question 8. Which of the following are not true with respect to junk bonds?

A) They are essentially the same as deep discount bonds
B) They offer yields higher than investment grade bonds
C) They have default rates higher than those of investment grade bonds
D) They are NEVER classified as investment quality bonds
E) B and C

Question 36

Question 2. Which of the following investments are quoted as a percentage of par?

A) Treasury bonds
B) Treasury notes
C) Treasury bills
D) A and B
E) B and C

Question 37

Question 7. Which of the following is not true with respect to debentures?

A) A debenture is unsecured and backed only by the full faith and credit of the issuing company
B) Debentures have junior claim to all aspects relative to all other forms of bonds
C) Claims of debentures are equal to those of general creditors
D) In the case of liquidation subordinated or junior debentures are paid after regular debenture holders
E) All of the above are true about debentures

Question 38

Rick Kilpatrick is thoroughly confused with the tax information he received from his mutual fund investment. What is most puzzling to him is the fact that he is asked to pay taxes on this investment even though he did not "touch" his mutual fund during the year. Can you clarify this situation?

Question 39

Which of the following are not true with respect to preferred stocks?

A) The board of directors does not have to approve dividend payments
B) In the case of liquidation, preferred stockholders have prior claim on the companies assets over common stocks
C) They have fixed income characteristics
D) They may be cumulative or non-cumulative
E) They typically do not participate in general management issues

Question 40

Question 16. Which of the following are reasons for purchasing a mutual fund?

A) Professional management
B) Tax reduction
C) Diversification
D) A and C
E) B and C

Question 41

Question 25. All of these are true for Spiders SPDRs) except:

A) They are bought through a brokerage
B) They are traded at exchanges like stocks
C) They can be sold short
D) They are a new type of bug that infested the NYSE

Question 42

The swaps are most appropriate for:
I. Fund managers
II) Individual investors
III) Big institutional investors
IV) Retirement plan investors

A) I and II
B) II and IV
C) I, II, and III
D) I and III

Question 43

Question 30. A put option: I. Is a form of derivative
II) Gives the holder the right to sell the underlying asset by a certain date at a certain price
III) Is used to protect price declines
IV) Authorizes the holder to "put away" a stock
V) Is traded on Chicago Board Options Exchange

A) All the statements are correct
B) Only IV is correct
C) Only IV is incorrect
D) II, III, and IV are correct
E) III, IV, and V are correct

Question 44

Question 18. Money market funds usually invest in:

A) Commercial paper
B) Common stock
C) Short-term debentures
D) A and C
E) All of the above represent money market investments

Question 45

Question 22. Index funds are a good investment during:

A) Declining market
B) Advancing market
C) Stable market
D) All of the above

Question 46

Question 35. The S&P index:

A) Is price-weighted, which means that weight is given only to the price of each stock
B) Allows the highest price stocks with the largest number of shares outstanding to carry the greatest influence in the movement of the index
C) Covers 86 industry groups, 400 industrial, 22 transport, and 40 financial companies
D) A and B
E) B and C

Question 47

Question 31. You sold a stock short. To calculate your cost basis for the stock you need to know:

A) Its purchase price
B) Its sale price
C) Both purchase and sale price
D) Its dividend yield

Question 48

Question 24. The following is true about iShares except:

A) They minimize portfolio turnover
B) They can be margined
C) Investors pay redemption fees when selling them
D) Investors pay a brokerage commission when selling them

Question 49

Question 26. Variable Annuity contract does all of these except:

A) Offers a variety of investment choices
B) Imposes a surrender charge
C) Allows a tax-deferred investment growth
D) Limits allowed annual contribution
E)

Question 50

Question 19. Fund Alphabet Soup refers to:

A) The proliferation of mutual funds in the marketplace
B) The several classes of shares now available to investors
C) The rating agencies which now rate all mutual funds
D) The conflict of interest planners have in selling load mutual funds
E) The way in which mutual funds are classified in the order of their quality

Question 51

Question 23. The iShares are:

A) Stocks
B) Index funds that trade like stocks
C) Traditional funds that trade like stocks
D) Fixed income securities

Question 52

Question 20. An index fund is a mutual fund which has the following characteristics:

A) It is tied to the cost of living index
B) It is generally more volatile than other volatile funds
C) It buys primarily small company stocks
D) It tries to match the ASE index
E) None of the above statements is true

Question 53

Question 28. Equity-indexed Annuity:

A) Limits upside potential but guarantees safety of principal
B) Limits upside potential and does not guarantee safety of principal
C) Guarantees a steady annual return
D) None of the above

Question 54

Question 21. All statements relating to index funds are true except:

A) They hold shares in all the companies of the index
B) They are no-load
C) They have no 12b-1 fees
D) They match exactly the performance of the index

Question 55

Question 27. In contrast to mutual funds, Variable Annuity:

A) Offers less investment choices
B) Has higher investment and insurance-related expenses
C) Is less tax-savvy
D) Is more risky

Question 56

Question 17. Which of the mutual funds should an investor purchase if he or she cannot tolerate stock market fluctuations?

A) Growth and income
B) Income
C) Index
D) Balanced
E) Maximum capital gain

Question 57

Question 29. Which of the following method allows to get higher returns for EIA:

A) Annual ratchet
B) Point-to-point
C) Depends on market conditions
D) None of the above